Chapter 2 and 3:

Accounting Concepts

© Stellenbosch University 2018

 Learning outcomes

• Understand the entity concept (2.3)

• Understand the concepts of financial position and equity

• Understand the accounting equation (3.1)

 What is Accounting?
Measuring process for economic entities (1.4 )
It is the financial value of an entity at a
Day 1 Financial position particular moment in time.
Expressed in a monetary value

Financial/Accounting activities
Trade between two or more parties Financial Period
Financial position
Day 2

(Has it improved or weakened? – Report)

Appendix A
What is an entity?

Need Money to start a business

Owners Loans
contribution

Assets
What is an entity?

Assets

Income

Profit

Expenses
What is Accounting?

Measuring process for economic entities

Financial position
Day 1

Financial/Accounting activities
Financial
Period

Financial position
Day 2
(Has it improved or weakened? – Report)

“rich or poor”
 Financial Position

• It is the financial value of an entity at a

particular moment in time
“rich or poor”
ASSET LIABILITY EQUITY

- =

Property Mortgage Bond Wealth

Accounting equation

ASSETS – LIABILITIES = EQUITY

ASSETS = LIABILITIES + EQUITY

A L E

Equation must always balance!

Owner’s interest / Equity

◦ Owner’s interest / Equity

◦ Result of accounting equation

◦ Represents the financial value

◦ Value of funds invested by the owner in the equity + profit or loss for the
period
 Owner’s interest / Equity

◦ Equity
• Result of accounting equation (E= A- L)
• Represents the financial value

Financial Position (A – L = Financial position)

• It is the financial value of an entity at a particular moment in time
• Expressed in a monetary value
Owner’s Interest / Equity
Need money to start business
Assets

Owners Loans

E + L Income Expenses
(+) (-)

=A

Assets
EPROFIT
Increases
financial
value
 Financial position

Day 1 Financial position (A – L = E)

Balance
Money/goods/services/rights(claims)
Classify
= Money/goods/services/rights(claims)

Day 2
Financial position (A – L = E)

(Compile a financial report on the financial position)

Example of classification
Beginning of the period:
◦ Assets: R 500
◦ Liabilities: R 200
◦ Equity: R 300

A – L =E
500 – 200 = 300
Example of classification (cont.)
◦ Buy a vehicle on credit for R100

VEHICLE = ASSET CREDIT=LOAN=LIAB

Increase in Assets Increase in Liabilities
Of R100 of R100

A - L = E
(+100) – (+100) = 0
100 - 100 =0
 Start A– L = E
date
R 500 – R 200 = R 300

Subsequent
Purchase Vehicle
date Assets ↑ R100; Liabilities ↑ R100

End A– L = E
date
R 600 – R 300 = R 300

R500 + R200 +
R100 R100
Example 2
Beginning of the period:
◦ Assets: R 800
◦ Liabilities: R 300
◦ Equity: R 500

A – L = E
800 – 300 = 500
Example 2 (cont.)
◦ Buy a computer for cash for R200

COMPUTER = ASSET CASH=BANK=ASSET

Increase in Assets Decrease in Assets
Of R200 of R200

A - L = E
[(+200) + (-200)] – 0 = 0
0 - 0 =0
 Start
date
A– L = E
R 800 – R 300 = R 500

Subsequent
Purchase Computer
date Assets↓R200 ; Assets ↑ R200

End A– L = E
date
R 800 – R 300 = R 500
R800 +
R200 –
R200
 REFRESH!
Accounting equation

Financial position Equity is the

& activities result of the
classified in terms equation
of this equation
 REFRESH!
Equity
• Result of accounting equation
• Represents the financial value

Financial Position
• It is the financial value of an entity at a particular moment
in time
• Expressed in a monetary value
 IMPORTANT
• Study the definition/concepts of financial position and equity

• Memorize the accounting equation

• Study Chapter 2.2.4 – 2.2.6 in the prescribed book

IS STATIONERY AN ASSET OR
AN EXPENSE, AND
WHY DO YOU SAY THAT???
The accounting measurement process…..

Financial position

Financial activities
Financial activities

Financial position

(Has it improved or weakened? – Report)

Appendix A
 FINANCIAL POSITION?
◦Financial value of an entity
THUS: How “Rich or Poor” is the entity?
◦“Rich or poor” =
◦How many assets? How much property?
◦How many debts? How many liabilities?
… financial value is what remains
after the debts have been deducted
from the assets
ACCOUNTING EQUATION
◦THUS: the wealth of an entity is:

Financial position = Assets – Liabilities

(owner’s equity)

◦ Owner’s equity:
◦ = Result of the equation
◦ = Financial position
◦ = value of funds invested by the owner
ACCOUNTING EQUATION

A–L=E

A=L+E
The accounting measurement process…..

Financial position
A–L=E
Day 1

Money/Goods/Services/Rights given = Classify

Money/Goods/Services/Rights received

Day 2 A–L=E
Financial position

(Has it improved or weakened? – Report)

Appendix A
Accounting equation

A–L=E

Financial position
and activities Equity is the
classified in terms result of the
of this equation equation
Learning outcomes
• Identify and define the elements of financial statements (2.2.4
→2.2.6)

• Formulate the extended accounting equation (3.1)

 Elements (2.2.4)
A – L = E
• A present economic RESOURCE
• CONTROLLED by the entity
• as a result of PAST EVENTs
• An economic resource is a right that has the potential to
produce ECONOMIC BENEFITS
 ASSETS
Controlled =

•Owner (legal title) or

•Must control the advantages from having asset in
your possession

Economic benefits =

• Potential of asset to directly or indirectly contribute

to the inflow of cash to the entity
 ASSETS
◦ Economic benefits flow in number of ways:

• Used singly or in combination with other assets

in the production of goods or services to be sold
by the entity
• Exchanged for other assets
• Used to settle a liability
• Distributed to the owners of the entity

◦ Asset recognition is appropriate if it results in RELEVANT AND

FAITHFULLY REPRESENTED information.
 ASSETS

◦ Tangible or Intangible (Goodwill / Trademark)

 ASSETS
◦ Classified: Non-Current & Current

•Expected lifespan in entity

o > 12 months = Non-Current (Long-term)
o < 12 months = Current (Short-term)

•Purpose for which asset was acquired

oTo utilise asset for a long period to generate
income = Non-Current
oTo sell asset as quickly as possible (convert to
cash) = Current
 ASSETS

NON-CURRENT
•Land and
Buildings CURRENT
•Machinery •Inventory
•Vehicles •Debtors
•Investments •Cash in bank
•Equipment •Petty Cash
•Trademarks
•Patents
 ASSETS
Is a motor vehicle a current or non-current asset?

Depends:
o if used as a delivery vehicle
= Non-current

oif main business is to buy and sell vehicles

= inventory = Current asset
 Elements (2.2.4)
A – L = E
• A present obligation of the entity
• to transfer an economic resource
• as a result of past events
• An obligation is a duty or responsibility that the entity has
no practical ability to avoid.
 Elements (2.2.4)
A – L = E
Goods/Services

ENTITY SUPPLIER

Money

• Entity pays supplier on credit

• Supplier has legal right/claim against entity
• Therefore, entity has an obligation to pay
because goods were received
 LIABILITIES
◦ Perform/pay on specific dates – terms
agreed at the transaction
◦ Outflow of resources in a number of ways:

• The payment of cash

• The transfer of assets
• The provision of services
• The replacement of one
obligation with another
• The conversion of an obligation
into equity
 LIABILITIES

• Classified: Non-Current & Current

Expected term/period over which

◦
liabilities have to be redeemed:
o > 12 months = Non-Current
(Long-term)
o < 12 months = Current
(Short-term)
 LIABILITIES

NON-CURRENT CURRENT

• Bank overdraft
• Long-term loans (Long • Creditors
term portion) • Provisions
• Mortgage loans • Long-term loans (Short term
portion)
 Elements (2.2.4)
A – L = E

• Residual interest
A–L
Result of the equation

Not market value of shares

• Represents the financial value

• Value of funds invested by the owner

 EQUITY

CAPITAL PROFIT/LOSS
3
1 Capital Contributions Difference between
(owner give to entity for income and expenses
activities)
(Ordinary financial 4
2 Capital Withdrawals activities of the business)
(owner take for personal
use)
 CAPITAL
Capital Contributions : +Ci
1 •Owner makes available to entity money/goods
•In return owner receives obligation (legal right/claim) against
entity
•Increase in owner’s equity (interest)

-D
Capital Withdrawals :
2
•Money/goods delivered to owner by entity for personal use
•The obligation (legal right/claim) of entity decreases
•Decrease in owner’s equity (interest)
SUMMARY OF EQUITY

1 Capital Contributions –
2 Drawings +
3 Income/Profits –
4 Expenses/Losses

Ref:
3.1
 3 INCOME
•Value that entity earned when entered into a transaction
•When entity delivers a service / sale of products

• Increases in assets,
• or decreases in liabilities,
• that result in increases in equity,
• other than those relating to contributions from holders of
equity claims
 INCOME +Po
+I
REVENUE GAINS

•Proceeds of the
sale of asset > cost
Arise in course of price
ordinary activities •Increase owner’s
equity – net
increase in asset
 4
EXPENSES
•Cost incurred during transactions
•Service rendered by another party to the entity OR
•Goods purchased that will probably hold no future
economic benefits for the entity

• Decreases in assets,
• or increases in liabilities,
• that result in decreases in equity,
• other than those relating to distributions to holders
of equity claims
-E EXPENSES -Lo

CURRENT LOSSES
EXPENSES

•Proceeds of the sale

of asset < cost price
Arise in course of
•Decrease owner’s
ordinary activities
equity – net decrease
in asset
Example
Extended equation
Basic equation A = L + C (C=capital=equity=E)

EQUITY = Contributions (Ci) – Drawings (D) + Revenue (I) +

Gains (Po) – Current expenses (E) – Losses (Lo)
Ledger
Therefore: A = L +(Ci – D + I + Po – E – Lo) account in
the form of a
“T”
Therefore: A + D + E + Lo = L + Ci + I + Po

Ref:
3.1
EXTENDED EQUATION

Debit Credit

Ref:
3.1
 Ref:
3.1

Debits and credits

A+ D+E/LO = Ci+I/PO+L

+ - - +

Asset Drawings Expenses Contribution Income/ Liability

/Losses owners profit
Recognition and
measurement of elements
LEARNING OUTCOMES

• Apply RECOGNITION criteria to the

elements of financial statements (2.2.5)

• Apply MEASUREMENT principles to the

elements of financial statements (2.2.6)
 THE ACCOUNTING
MEASUREMENT Thought
process….
1. Define element

2. Recognition of element

3. Measure the element

 Step 2:
Recognition
OF AN ELEMENT
Criteria
Ref:
2.2.5
When can I recognise an
element?

1.Complies with definition:

• Asset/Liability/Income/Expense

2. Recognition criteria
AND

Ref:
2.2.5
 Recognition of assets
◦ Asset recognition is appropriate if it results in RELEVANT AND
FAITHFULLY REPRESENTED information.

 RELEVANT  FAITHFUL
REPRESENTATION
 Affected by:
 Low probability of a
 Affected by:
flow of economic  Measurement
benefits uncertainty
 Recognition
 Existence uncertainty
inconsistency
 Presentation and
Ref:
disclosure
2.2.5
 Recognition of liabilities
◦ Liabilities recognition is appropriate if it results in RELEVANT AND
FAITHFULLY REPRESENTED information.

 RELEVANT  FAITHFUL
REPRESENTATION

 Affected by:  Affected by:

 Low probability of a  Measurement
flow of economic uncertainty
benefits  Recognition
 Existence uncertainty inconsistency
 Presentation and Ref:
disclosure 2.2.5
LAW SUIT AGAINST YOUR FIRM
– do I RECOGNISE THIS?
Your lawyer tells you the following:

• You will definitely have to pay damages

to the worker
• The amount is not estimated yet
LAW SUIT AGAINST YOUR FIRM
– do I RECOGNISE THIS?
Your lawyer tells you the following:

• The amount of the claim is R1 million

• At this stage there is no certainty whether
you will be liable
LAW SUIT AGAINST YOUR FIRM
– do I RECOGNISE THIS?
Your lawyer tells you the following:

• The amount of the claim is R1 million

• You have to pay this in one month’s time
 Recognition of income/gains and
expenses/losses
The, financial statements/ recognition of incomes and expenses, are linked because the
recognition of one item (or a change in its carrying amount) requires the recognition or
derecognition of one or more other items (or changes in the carrying amount of one or
more other items).

For example:
(a) the recognition of INCOME occurs at the same time as:
(i) the initial recognition of an asset, or an increase in the carrying amount of an asset; or
(ii) the derecognition of a liability, or a decrease in the carrying amount of a liability.

(b) the recognition of EXPENSES occurs at the same time as:

(i) the initial recognition of a liability, or an increase in the carrying amount of a liability; or
(ii) the derecognition of an asset, or a decrease in the carrying amount of an asset.

Ref:
2.2.5
 Measurement basis
- How to measure elements at a specific point in time (ex. 31 Dec)

1. Historical cost:
• Purchase Price at transaction date or the fair value given

2. Current cost:
• Price now-acquire same asset/settle obligation (replacement)

3. Realisable value:
• Amount obtained by selling asset / settle liability in ordinary course of
business

4. Present value:
• Present discounted value of future cash flows

Ref:
2.2.6
 Measurement example:
At 31 December 2016
ABC (Pty) Ltd had 1 Bakkie
that is uses to deliver
packages

A dealership
offered The bakkie is
R210,000 for expected to
This bakkie A similar new
our bakkie bring in
was bought bakkie today
today income of
on 1 May costs R50,000 a
2016 for R270,000 year for the
R245,000
next 5 years.
Conceptual
Framework
Conceptual framework

… an international accounting
standard that precedes all the rest

Enhancing Qualitative aspects of FS

Underlying assumptions of FS
Definition of elements of FS
Recognition and measurement of FS
Conceptual framework

What characteristics should

the financial statements
have?
QUALITATIVE CHARACTERISTICS
A) Fundamental Qualitative characteristics
1. Relevance
2. Faithful representation
B) Enhancing Qualitative characteristics
1. Comparability
2. Verifiability
3. Timeliness
4. Understandability

Ref:2.2.2
FUNDAMENTAL qualitative
characteristics
1. Relevance
➢USEFUL Information that has the ability to influences
decisions of users:
➢Predictive value → Use information to make predictions
➢Confirming value → Confirms previous evaluations

➢The materiality of information must also be taken into

account to determine the relevance thereof

When its omission or misstatement influences the economic

decisions of users who rely on the financial statements
Ref:
2.2.2.1
FUNDAMENTAL qualitative
characteristics
2. Faithful representation
◦ information must faithfully represent the substance of what it purports
to represent

◦ a faithful representation is, to the maximum extent possible, complete,

neutral and free from error

◦ a faithful representation is affected by level of measurement

uncertainty
Ref:
2.2.2.1
ENHANCING

Comparability
➢Compare information over time and between
similar entities
➢Comparable figures for at least 1 year in
financial statements

Ref:
2.2.2.2
 ENHANCING

◦ Verifiability
➢Verifiability helps assure faithful representation
➢Independent observers reach consensus

Bank Balance = R10 000

Ref:
2.2.2.2
ENHANCING

◦ Timeliness
➢Information must be available on a timely basis
for users to influence their decisions

Ref:
2.2.2.2
ENHANCING

◦ Understandability
➢Accept that users of the information
have reasonable knowledge of business
/ accounting activities and that they will
be prepared to study the information
single-mindedly

Ref:
2.5.2
CONSTRAINTS

• Self study

Ref:
2.2.2.3
 Underlying assumptions (2.2.3)

◦ Accrual assumption (2.2.3.1)

➢ Transactions are recorded when they occur
regardless of when cash is paid/received.

◦ Going concern(2.2.3.2)
➢ Assumption that the entity will continue to exist for
the 12 months after its reporting date.
 Illustration of accrual concept

BEGINNING OF
NEXT MONTH
UNDERLYING ASSUMPTIONS

◦ GOING CONCERN
➢ Assume entity will continue to be in
business in foreseeable future

Ref
2.2.3.2