Professional Documents
Culture Documents
Abrena
Accounting
Fundamentals of
ABM-1
Accounting Concept and Principles
1. 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.
2. 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.
Deferred Taxation
IAS 12 Income Taxes and FAS 109 Accounting for Income Taxes require the accounting for taxable and deductible
temporary differences arising in the calculation of income tax in a manner that results in the matching of tax
expense with the accounting profit earned during a period.
Government Grants
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires the recognition of
grants as income over the accounting periods in which the related costs (that were intended to be compensated by
the grant) are incurred by the entity.
5. 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.
6. 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.
7. 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.
8. 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.
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 inter-company 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.
Example
XYZ PLC is a company specializing in the manufacturing of fertilizers. At the start of the current accounting period, XYZ
PLC acquired DEF PLC, a chemicals producer.
Following is a summary of the financial results of the two companies during the year:
XYZ
$m
120
(60)
60
(20)
40
Sales
Cost of Sales
Gross Profit
Operating Expenses
Net Profit
DEF
$m
50
(20)
30
(10)
20
XYZ PLC purchased chemicals worth $20m from DEF PLC which it used in the manufacture of fertilizers sold during the
year.
Consolidation of XYZ Group's financial results will require an adjustment in respect of the inter-company sale and purchase
in order to conform to the single entity principle.
Consolidated financial results of the two companies will be presented as follows:
Sales
Cost of Sales
Gross Profit
Operating Expenses
Net Profit
(120 + 50 - 20)
(60 + 20 - 20)
(20 + 10)
XYZ Group
$m
150
(60)
90
(30)
60
Since XYZ Group, considered as a single entity, cannot sell and purchase to itself, the sales and purchases in the
consolidated income statement have been reduced by $20 m each in order to present the sales and purchases with
external customers and suppliers.
If we ignore the single entity concept, XYZ Group's financial results will present sales of $170 m and cost of sales
amounting $80 m. Although the net profit of the group will be unaffected by the inter-company transaction, the size of the
Group's operations will be misrepresented due to the overstatement.
11. 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.
12. Understandability
Transactions and events must be accounted for and presented in the financial statements in a manner that is easily
understandable by a user who possesses a reasonable level of knowledge of the business, economic activities and
accounting in general provided that such a user is willing to study the information with reasonable diligence.
Understandability of the information contained in financial statements is essential for its relevance to the users. If the
accounting treatments involved and the associated disclosures and presentational aspects are too complex for a user to
understand despite having adequate knowledge of the entity and accountancy in general, then this would undermine the
reliability of the whole financial statements because users will be forced to base their economic decisions on undependable
information.
13. 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.
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.
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.
Mr. A, who owns and operates a bookstore, has identified the following transactions for the month of January that need to
be accounted for in the monthly financial statements:
$
1. Payment of salary to staff
2. Sale of books for cash
3. Sales of books on credit
4. Receipts from credit customers
5. Purchase of books for cash
6. Utility expenses - unpaid
2,000
5,000
15,000
10,000
20,000
3,000
Under double entry system, the above transactions will be accounted for as follows:
Account Title
Effect
Debit
$
1. Salary Expense
Cash at bank
Increase in expense
Decrease in assets
2,000
2. Cash in hand
Sales revenue
Increase in assets
Increase in income
5,000
3. Receivables
Sales revenue
Increase in assets
Decrease in income
15,000
4. Cash at bank
Receivables
Increase in asset
Decrease in asset
10,000
5. Purchases
Cash at bank
Increase in expense
Decrease in asset
20,000
6. Utility Expense
Accrued expenses
Increase in expense
Decrease in asset
3,000
Credit
$
2,000
5,000
15,000
10,000
20,000
3,000
Accounting Formulas
Managing your business finances and revenues can be a full-time job, and you might even have a full-time accountant on
staff to handle the books. Many small business owners, however, prefer to handle this aspect of their businesses
themselves, foregoing an accountant in order to maintain control over their own books.
If you fall into the latter category, here are some standard accounting formulas you should know. These formulas are
generally regarded as universal to any business and will provide you with the figures you need to understand the viability
and health of your business.
Assets are all of the things your company owns, including property, cash, inventory and equipment that will provide
you with a future benefit.
Liabilities are obligations that you must pay, including things like lease payments, merchant account fees and debt
service.
Owners Equity is the portion of the company that actually belongs to the owner.
2. Net Income
Equation: (Revenues Expenses = Net Income)
What It Means:
Revenues are the sales or other positive cash inflow that comes into your company.
Expenses are the costs that are associated with making sales.
By subtracting your revenue from your expenses, you can calculate your net income. This is the money that you
have earned at the end of the day. Its possible that this number will be negative when your business is in its
nascent stage, so the goal is for your business net income to become positive, meaning your business is profitable.
3. Break-Even Point
Equation: (Break-Even Volume = Fixed Costs / Sales Price Variable Cost Per Unit)
What It Means:
Fixed Costs are recurring, predictable costs that you must pay in order to conduct business. These costs include
insurance premiums, rent, employee salaries, etc.
Sales Price is the retail price you sell your products or services for.
Variable Cost Per Unit is the amount it costs you to make your product.
If you divide your fixed costs by the sale price of your product, minus the amount it costs to make your product,
youll have a break-even point, which tells you how much you need to sell in order to cover all of your costs.
4. Cash Ratio
Equation: (Cash Ratio = Cash / Current Liabilities)
What It Means:
This gives you an idea of how much cash you currently have on hand.
Cash is simply the amount of cash you have at your disposal. This can include actual cash and cash
equivalents (i.e. highly liquid investment securities).
Current Liabilities are the current debts the business has incurred.
This ratio demonstrates how well your business can pay off its current liabilities. In this case, the higher the number,
the healthier your company.
5. Profit Margin
Equation: (Profit Margin = Net Income / Sales)
What It Means:
Net Income is the total amount of money your business has made after expenses have been removed.
When you divide your net income by your sales, youll get your organizations profit margin. A high profit margin
indicates a very healthy company. A low profit margin can reveal how unsuccessful a company might be, but it can
also mean that your organization doesnt handle its expenses well. Remember that your net income is made up of
your total revenue minus your expenses. If you have high sales revenue, but still have a low profit margin, it might
be time to take a look at the figures making up your net income.
6. Debt-to-Equity Ratio
Equation: (Debt-to-Equity Ratio = Total Liabilities / Total Equity)
What It Means:
Total Liabilities include all of the costs you must pay to outside parties, such as loan or interest payments.
Total Equity is how much of the company actually belongs to the owner or other employees. In other words, its the
amount of money the owner has invested in his or her own company.
A high debt-to-equity ratio illustrates that a high proportion of your companys financing comes from outside
sources, such as banks. If youre attempting to secure more financing or looking for investors, a high debt-to-equity
ratio might make it more difficult to land funding.
Cost of Materials/Inventory is the amount of money your company has to spend to secure the necessary products
or materials to manufacture your product.
By subtracting the cost of outputs from the cost of materials, youll know your cost of goods sold. This tells you if the
costs youre paying to make your product are in line with the revenue you earn when you sell it.
There are many more accounting formulas that you can use, but these seven are some of the more common. Its best to
have a good grasp of these formulas even if youre not planning to manage your own accounting. The more knowledge you
have regarding your finances, the better you can manage your business.