Accounting - module 2 - unit 2

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Unit 2 - Accounting Principles, Concepts and Conventions

1. Going Concern

This concept assumes that a business will continue to trade normally for the foreseeable future, unless the owners apply to go into bankruptcy or administration. Therefore, a sole trader should not go into bankruptcy within the next financial year, nor should a limited company go into administration within the next financial year. Hence, a business should be able to pay its creditors as debts fall due.

This concept has a major impact on how the balance sheet is prepared:

Non-current assets are valued at their cost less depreciation.

Capital is calculated as assets less liabilities.

The value of the capital will be equal to net assets.

if the business is not a going concern, assets are valued at their market value - this may be considerably less than their book value.

2. Cost

An asset should be recorded in the balance sheet at its cost, and this should include:

The cost of purchase

Delivery cost

Installation cost

The invoice will provide the cost of the asset to be recorded in the financial statements.

Example:

On 1st January 2013, a trader buys equipment for £21,000 with delivery and installation expenses amounting to £4,000.

In

the balance sheet, the asset will be valued at the cost of its purchase

and delivery and installation expenses = £21,000 + £4,000 = £25,000.

The

asset is assumed to have a life of 4 years and a scrap value of £1,000.

The trader will depreciate this new fixed asset using the straight line

method.

The straight line method for depreciation is (cost -

scrap value (residual)) / useful life in years = (£25,000 - £1,000) / 4

= £6,000.

£6,000 is the now the annual rate of depreciation.

The

trader is informed that a replacement for for the asset will now cost

£30,000, and and is therefore considering this as the valuation for the

asset in the financial statements.

The trader should still use the vehicle at cost, not the replacement cost.

3. Consistency

Consistency means that the financial statements are prepared using the same accounting policies from one year to the next, to ensure they can be truthfully and fairly compared overtime.

This prevents the owner from changing the accounting policies to influence the value of profits and capital unfairly and dishonestly, which will mislead potential investors.

For example, if the straight line method is used to depreciate a fixed asset, it should always be used when calculating the depreciation for that asset. Therefore, the trader should not switch to the reducing balance in the later years of the asset's life to boost profits, as it will generate a lower depreciation charge.

For example:

A trader has put his business up for sale. In that year ha made a net profit of £5,000, and his capital was £15,000. However, he had switched his method of calculating depreciation from the straight line method to the reducing balance method to boost his profit and capital values. Under the straight line method, depreciation was £6,000, but under the reducing balance method, depreciation was £2,000.

The difference in value between the two methods used = £4,000.

The correct value for net profit should be: £5,000 - £4,000 = £1,000.

The correct value for capital should be £15,000 - £4,000 = £11,000.

It is wrong for a trader to switch account policies because the trader is not being consistent, and so the financial statements cannot be compared with previous years. This will mean that the statements are neither true or fair, and potential investors may be misled.

4. Prudence

The prudence concept implies that losses should be recognised as soon as they are known and profits only when they are proven. This is to ensure that profit and asset values are not overestimated, and the capital base is protected from overspending.

If profits are over-estimated, the owner may spend and withdraw more cash than is prudent, and this may cause the business to become insolvent or be declared bankrupt because creditors cannot be paid as debts fall due.

1. Inventories should be valued at their lowest cost or net realisable value. Net realisable value is the sale price less any repair cost. For emaple:

Items of stock that cost £10,000 have become damaged and need £3,000 to have them repaired.They can then be sold for £12,000.

Cost = £10,000.

Net realisable value = £12,000 - £,3000 = £9,000.

The stock should be valued at £9,000 because it is the lowest value.

2. Bad debts should be written off as soon as they are known.

3. Bad debts recovered should only be recognised when the money has been received.

4. A provision for doubtful debts should be set up for future bad debts.

5. Non-current (fixed) assets are depreciated to reflect their finite life and to provide for their replacement.

5. Matching

Revenue and expenses should be matched to the accounting period in which they were generated from when calculating profit. This means that items are adjusted for accruals and prepayments, which are calculated using APES.

In this example, Energy and Rates are the overheads (expenses).

A bank payment for an expense is recorded in the debit side of the expense account, as it is credited in the bank account.

Energy has been accrued at the start of the year, and prepaid at the

end of the year. Therefore, the value in the income statement will be:

Opening bank payment - accrual - prepayment.

This is

recorded on the credit side of the ledger.

Rates have been prepaid at the start of the year and accrued at the

end of the year. Therefore, the value in the income statement will be:

Opening bank payment + prepayment + accrual.

This is also

recorded on the credit side of the ledger.

The accrual for energy is at the start of the year, and must therefore be recorded in the credit side of its ledger.

The prepayment for rates is at the start of the year, and must therefore be recorded on the debit side of its ledger.

The total for the energy account is then calculated, and the balance

c/d on the credit side is equal to the prepayment, which is then

bought down on the debit side to show that energy has been prepaid for

the next financial year.

The total for the rates account is calculated, and the balance c/d

on the debit side is equal to the accrual which is then brought down on

the credit side to show that rates are accrued going into the next

financial year.

6. Business Entity

This concept states that the business has a seperate entity to its owner in its own right, and is therefore distinct from the owner.

This means that the owner's private transcations are treated separately from business transactions.

Therefore, the drawings of an owner must be treated as a deduction from capital, and not as a deduction from profits.

Drawings occur when the owner takes assets owned by the business for their personal use, such as vehicles, stock or cash.

The amount should be debited to the drawings account and credited to the asset account.

Drawings reduce the value of capital.

For example:

1. A trader has paid for a £700 holiday using money received from cash sales.

Debit drawings £700 / credit cash £700

2. A trader takes stock drawings to the value of £1,300.

Debit drawings £1,300 / credit cash £1,300.

3. A trader withdraws £1,000 from the bank every month for personal use.

Debit drawings £1,000 / credit bank £1,000.

In this example, the annual charge for drawings is:

£700 + £1,300 + (£1000 x 12) = £14,000.

Drawings are treated as a withdrawal from capital, and are therefore deducted from capital in the balance sheet.

7. Realisation

This concept states that revenue is considered to have been earned by the trader on the date it has been realised. This is when the goods have been accepted by the customer from the supplier.

This is to prevent the owner from recording revenue and profits on goods before they have been sold or delivered to a customer.

A trader may supply a customer with goods on a sale or return basis, meaning that they are supplied to a customer on the assumption that if they are not sold, they are to be returned without any payment being required. These goods still belong to the supplier until ownership is accepted by the customer.

The trader CAN count credit sales as revenue because the customer has already accepted the goods, and is able to pay for them within the next financial year.

8. Materiality

Materiality is concerned with the impact an accounting transaction will have on the financial statements.

The accountant must deal with a financial transaction in accordance to the normal accounting procedure, UNLESS the amount involved is too insignificant and therefore unlikely to have a material impact on the financial statements such as the income statement and the balance sheet.

Therefore, non-current assets should be depreciated over their useful life, because failure to do so would have a material impact on the profit, asset and capital values.

However, it is not necessary to apply the normal procedure to very small items of capital expenditure. A business may treat expenditure on office staplers as revenue expenditure instead of capital expenditure (even though it will benefit the business for more than one year). This is because the amount involved is too small to materially affect the financial statements.

Finally accountant should consider how the treatment of financial transactions will affect the way in which the user views the financial statements:

The income statement and balance sheet should be prepared in a way that does not mislead the viewer.

Depreciation on non-current assets and other large expenses should not be ignore as they are material and have a significant impact on the financial statements.

However, capital expenditure on items of very small cost should be treated as revenue expenditure as they are not material.

If the materiality concept is not applied, then the accounts are not true or fair.

9. Objectivity

This concept implies that financial statements should be objective - based on facts, and not subjective - based on opinions. Therefore:

The cost of assets should be based on factual evidence such as an invoice, and not the opinion of the trader.

The financial statements should be prepared in a format that is universally accepted, and can therefore be understood by a variety of users.

Therefore, this will avoid misleading potential investors.

Summary

The purpose of accounting concepts and conventions is to ensure that the accounts represent a true and fair view of the assets, capital, liiabilities and profit of a business.

Truth implies that the accounting treatment can be proven e.g. recording the purchase of a non-current asset at its cost price, which is based on the the invoice provided by the supplier.

Fairness implies that the accounting treatment is reasonable e.g. the depreciation of non-current assets over their useful life.

Accounting - module 2 - unit 2