Chapter 9

Notes to teachers
1 2

Fundamental Accounting Concepts and Principles

This is the most difficult topic for students in the Compulsory Part. It is also difficult to teach as many related accounting topics have not been learnt and thus not many examples can be given. Therefore, you should not go into great detail about the accounting concepts and principles in this chapter. It is sufficient for students to understand the general meaning of a concept and be given one or two simple examples.

Q1

(a) Dr Cash Cr Capital (b) Dr Drawings Cr Purchases

Q2

(a) This should not be recorded in the books of the business because the transaction had nothing to do with the business. (b) This should be recorded in the books of the business as follows: Dr Drawings Cr Cash/Bank

Q3

The business entity concept is not violated. Although the firm is owned by Mr Wong, Mrs Wong works for the firm and not for Mr Wong. The salary paid to Mrs Wong should not be treated as Mr Wongs drawings even though they are married. The historical cost of an asset refers to its original cost of purchase or cost of production. (a) The assets should be valued at historical cost, as they are likely to be kept in use by the business for the foreseeable future instead of being sold. (b) The assets should be valued at current market value, as they are likely to be sold in the near future.

Q4 Q5

Q6

This is because the business could have credit sales during the year and some debtors have not yet paid their accounts. Sales should be recognised as revenue when sales transactions are completed (i.e. when goods or services have been provided), and not when cash is received from debtors. According to the accrual concept, only three months of insurance, from 1 October 2005 to 31 December 2005, should be recognised as an expense for the year ended 31 December 2005. The other three months of insurance, from 1 January 2006 to 31 March 2006, represents payment in advance and should be treated as an expense for the following year.

Q7

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Q8

The consistency principle requires the same accounting policy or method be applied to similar items. A change is allowed only if it can give a more accurate view of a business. With the application of the consistency principle, it would be more difficult to manipulate a firms financial results by switching to a more favourable accounting method. In addition, the financial statements of the same firm in different periods, or the financial statements of different firms, can be fairly compared as a result.

Q9

No. A firm can change the accounting policies or methods it uses, if such a change is necessary and can give a more accurate view of the business. When a change in accounting policy or method occurs in a certain year and the profits calculated for that year are affected significantly, the effects of the change should be disclosed and explained.

A1

The above practice violates the business entity concept. Each firm should be treated as a separate entity, even though both firms are owned by the same person and operate in the same industry. Separate accounting records should be kept for each firm and a separate set of financial statements should be prepared for each firm. Valuation of assets at historical cost does not reflect the current value of assets. Therefore, the assets of a business may be undervalued (or overvalued) when market prices have gone up (or down). (Any reasonable answers) If a firm is going to be wound up, its assets are likely to be sold in the near future. Valuation at current market value can better reflect the true value of the firms assets. The business entity concept excludes the personal transactions of the owner(s) as they are unrelated to the business. It therefore makes accounting information more relevant and useful to decision-makers. The historical cost principle makes the valuation of assets more objective. The going concern concept supports the application of the historical cost principle. The going concern concept and the historical cost principle are closely related. The measurement of expenses and revenues on an accrual basis reflects the flows of a firms economic resources (not just cash) more fairly. The consistency principle requires businesses to apply the same accounting policies and methods to similar items, thus makes accounting information more uniform and comparable. When all businesses follow the same accounting principles and concepts in the preparation of accounting records and financial statements, accounting information would be more objective, uniform and useful to decision-makers.

A2

A3 A5

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According to the accrual concept, revenues are recognised when earned, not when money is received. So, sales are recorded when goods have been delivered to and accepted by customers, even though payments have not been received. The business entity concept states that a business is treated as an entity separate from its owner(s) and therefore, only the transactions affecting the business should be recorded in the books of the business. As the air ticket was paid out of business money but for the owners private use, it should be treated as drawings and deducted from the owners capital.

The historical cost principle states that the assets of a business should be valued at their original cost of purchase or production. So, the delivery van should be recorded at its actual cost of purchase ($60,000) instead of its current price ($70,000).

ASSESSMENT

MCQ
1 A 2 B 3 B 4 C 5 D

Exercises
6
(a) (i)  The revenues and expenses of a firm are measured on an accrual basis, and not on a cash basis. Accordingly, revenues should be recognised when earned and expenses should be recognised when incurred, and not when money is received or paid. For example, some goods were sold on credit in December 2009. The credit sale should be included in the firms revenues for the year ended 31 December 2009, even though payment had not been received by the year end. (Any relevant examples) (ii)  The consistency principle requires the same accounting policy or method be applied to similar items. A change is allowed only if it can give a more accurate view of a business. For example, various methods can be used to calculate depreciation on non-current assets, including the straightline method and the reducing-balance method. Once a firm has adopted a depreciation method for a certain type of non-current asset, it should keep using the same method for that type of noncurrent asset year after year. (Any relevant examples)

(b) (i)  The business entity concept is violated. The profit from the owners private investments should not be recorded in the income statement of the business. However, if the $6,000 is put into the business, it should be recorded as additional capital contribution by the owner. (ii)  The historical cost principle is violated. The assets of a business should be valued at cost and not at market value, unless the going concern assumption is no longer valid. In that case, the assets should be valued at current market value.

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7X

(a)  According to the historical cost principle, the car should be valued at its original cost of purchase, i.e., $68,000. (b)  According to the historical cost principle, the machinery should be valued at its actual cost of purchase, i.e., $75,000.

(a)  According to the accrual concept, interest expense should be recorded when it is incurred, even if it has not been paid. As the loan was borrowed in 2006, interest was incurred as from the date of borrowing and should be treated as an expense for the year ended 31 December 2006. (b)  According to the historical cost principle, assets should be shown at cost rather than market value. Historical cost is generally regarded as more objective and also more relevant when the business is treated as a going concern. (c)  According to the consistency principle, the same depreciation method should be applied to similar assets. A change is allowed only if it can give a more accurate view of a business. The depreciation method should not be changed simply to increase the reported net profit.

9X

(a)  According to the business entity concept, a business and its owner(s) should be treated as separate entities.The clock is for J Wongs personal use rather than for business purposes. Therefore, it should be treated as drawings by the owner. (b)  According to the accrual concept, revenue should be recorded when it is earned and not when money is received. As the sales transactions were completed in the current year, they should be recognised as revenue in the current year.

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