Professional Documents
Culture Documents
1
Forms of Business Entities
2
Example No-1:
If a business owes a supplier Rs. 1,000 for goods it has purchased,
but does not have the money to make the payment, the owner of
the business is personally liable to make the payment out of
his/her other assets.
Example No-2:
If a partnership owes a supplier Rs. 1,000 for goods it has
purchased, but does not have the money to make the payment,
the partners are personally liable to make the payment.
3
Accounting concepts
Actually there are a number of accounting concepts and
principles based on which we prepare our accounts
These generally accepted accounting principles lay down
accepted assumptions and guidelines and are commonly
referred to as accounting concepts
4
Question: What is the objective of financial reporting?
Answer:
The objective of financial reporting is to provide financial
information about the reporting entity that is useful to
existing and potential investors, lenders and other creditors
in making decisions about providing resources to the entity.
5
Identify any four potential user groups who may be interested in an entity's
financial
statements and specify what type of information would be of interest to them.
User Groups and information that would be of interest to them:
• Investors require information to assess the ability of an entity to earn profits and to pay
dividends. Principally, they need to decide whether to buy, hold or sell shares.
• Employees and their representative groups (e.g. trade unions), require information to assess
the ability of an entity to provide remuneration, retirement benefits and employment
opportunities.
• Lenders are interested in information that enable them to determine whether their loans and
interest entitlements will be paid when due.
• Suppliers require information which will enable them to assess whether the entity has the
ability to pay amounts owed when they fall due.
• Customers are interested in assessing the continuance of an entity where they have a long-
term involvement with them and/or are dependent on them for supplies.
• Government and their agencies require information for a variety of purposes. These include
resource allocation decisions (e.g. government grants), to assess taxable capacity and for
regional and national planning purposes.
• Public is interested in variety of ways which include employment potential, Corporate Social
Responsibility (CSR) activities and for environment assessment purposes.
6
THE COMPONENTS OF FINANCIAL
STATEMENTS
A full set of financial statements would include the following:
• A statement of financial position;
• A statement of comprehensive income;
• A statement of changes in equity (not in this syllabus);
• A statement of cash flows (not in this syllabus) and
• notes to the financial statements (not in this syllabus)
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THE ELEMENTS OF FINANCIAL
STATEMENTS
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Assets
Meaning
a resource controlled by the entity;
as a result of past events; and
from which future economic benefits are expected to
flow to the entity.
9
Liabilities
Meaning
a present obligation of an entity
arising from past events
the settlement of which is expected to result in an
outflow of resources that embody economic benefits.
10
Equity/Capital
Meaning
Equity is the residual interest in an entity after the value
of all its liabilities has been deducted from the value of
all its assets.
Equity of companies may be sub-classified into share
capital, retained profits and other reserves.
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Income
Meaning
Income includes both revenue and gains.
Financial performance is measured by profit or loss.
Profit is measured as income less expenses.
Revenue is income arising in the course of the ordinary activities of
the entity. It includes sales revenue, fee income, royalties’ income,
rental income and income from investments (interest and dividends).
Gains include gains on the disposal of non-current assets. Realised gains
are often reported in the financial statements net of related expenses
A royalty payment is made to the legal owner of the property, patent,
copyrighted work or franchise by those who wish to make use of it for
the purposes of generating revenue or other such desirable activities.
12
Expenses
Meaning
Expenses arising in the normal course of activities, such as the cost
of sales and other operating costs, including depreciation of non-current
assets. Expenses result in the . outflow of assets (such as cash or finished goods
inventory) or the depletion of assets (for example, the depreciation of non-
current assets).
Losses include for example, the loss on disposal of a non-current
asset, and losses arising from damage due to fire or flooding. Losses
are usually reported as net of related income. Losses might also be unrealised.
Unrealised losses occur when an asset is revalued downwards, but is not
disposed of. For example, and unrealised loss occurs when marketable securities
owned by the entity are revalued downwards.
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Accounting Concepts
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Accounting Concepts
Business entity
Capital and Revenue Expenditures
Going Concern
Historical Cost
Prudence/conservatism
Materiality
Substance over form
Completeness
Objectivity
Consistency
Accruals/matching
True and fair view
15
Business Entity
Meaning
The business and its owner(s) are two separate existence entity
Any private and personal incomes and expenses of the owner(s) should
not be treated as the incomes and expenses of the business
It requires the use of separate accounting records for the organization
that completely exclude the assets and liabilities of any other entity or
the owner.
Example:
Imran Khan sets up a sole trader business as a builder, and he calls the
business ‘IK Builders’. Legally, IK Builders does not have a separate legal
personality. The debts of IK Builders are debts of Imran Khan. However,
for the purpose of financial reporting, the business is accounted for as
an entity separate from Imran Khan.
16
Capital expenditure
Capital expenditure is expenditure made to acquire or
improve long term assets that are used by the business:
Examples include:
purchase of property, plant and equipment, office
equipment; and motor vehicles;
installation costs associated with new equipment;
improvements and additions to existing non-current assets
(for example, building extensions, installation of air-
conditioning etc.)
Fees paid to raise long term finance are also deemed to be
capital in nature.
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OTHER EXAMPLES OF CAPITAL EXPENDITURES
Purchase of furniture, motor vehicles, electric motors, office
equipment, loose tools and other tangible assets.
Cost of acquiring intangible assets like goodwill, patents, copy
rights, trade marks, patterns and designs etc.
Addition or extension of assets.
Money spent on installation and erection of plant and machinery
and other fixed assets.
Wages paid for the construction of building.
18
Revenue expenditure
Revenue expenditure is expenditure on day-to-day operating
expenses.
Examples include:
Purchase of goods meant for resale in the normal course of
business;
Purchase of raw materials and components used to manufacture
goods for resale in the normal course of business;
Expenditures made to meet the day to day running costs of a
business (for example, rent, energy, wages etc.)
Expenditures made to repair non-current assets.
Expenditures made to distribute goods to customers.
Costs of administering a business (for example, accounting
services, license fees etc.)
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Example:
A business has two identical vehicles each with engine
problems.
Vehicle A engine is repaired – costs associated with the repair
are revenue expenditure
Vehicle B engine is replaced – this is capital expenditure.
Example:
A business entity borrows $100,000 from a bank for five years
and pays interest of $8,000 on the loan for the first year. The
loan is a non-current liability (and part of the long-term
‘capital’ of the business – a capital receipt) but the interest is
an expense (revenue expenditure).
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Following are the examples of revenue expenditure.
Wages paid to factory workers.
Oil to lubricate machines.
Power required to run machine or motor.
Expenditure incurred in the ordinary conduct and administration of business, i.e. rent, , carriage
on saleable goods, salaries, wages manufacturing expenses, commission, legal expenses,
insurance, advertisement, free samples, postage, printing charges etc.
Repair and maintenance expenses incurred on fixed assets.
Cost of saleable goods.
Depreciation of fixed assets used in the business.
Interest on borrowed money.
Freight, transportation, insurance paid on saleable goods.
Petrol consumed in motor vehicles.
Service charges to motor vehicles.
Bad debts.
21
Capitalisation, Revenue and capital
income
The IASB defines ‘capitalisation’ as recognising a cost as an asset
or part of the cost of as an asset. So when an item of cost is
‘capitalised’ it is treated as an asset rather than an expense.
Revenue income is income arising from the normal
operations of a business from its investments.
Examples include:
Revenue from the sale of goods.
Capital receipts are receipts of ‘long term’ income, such as
money from a bank loan, or new money invested by the
business owners (which is called ‘capital’).
22
Going Concern
Meaning
The business will continue in operational existence for the
foreseeable future
This means that financial statements are prepared on the
assumption that the entity does not intend to go into nor
will be forced into liquidation.
The going concern assumption is particularly relevant
for the valuation of assets.
23
Example
Possible losses form the closure of business will not be
anticipated in the accounts
Prepayments, depreciation provisions may be carried forward
in the expectation of proper matching against the revenues of
future periods
Fixed assets are recorded at historical cost
24
Historical Cost
Meaning
Assets should be shown on the balance sheet at the cost of
purchase instead of current value
Example
The cost of fixed assets is recorded at the date of acquisition
cost. The acquisition cost includes all expenditure made to
prepare the asset for its intended use. It included the invoice
price of the assets, freight charges, insurance or installation
costs
25
Prudence/Conservatism
Meaning
In the times of uncertainty assets and incomes should not be
overstated and liabilities and losses should not be
understated.
– Revenues and profits are not anticipated. Only realized profits
with reasonable certainty are recognized in the profit and loss
account
– However, provision is made for all known expenses and losses
whether the amount is known for certain or just an estimation
– This treatment minimizes the reported profits and the
valuation of assets
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Example
Stock valuation sticks to rule of the lower of cost and net
realizable value
The allowance for doubtful debts should be made
Fixed assets must be depreciated over their useful economic
lives
27
Materiality
Meaning
Information is material if omitting it or misstating it could
influence decisions that users make on the basis of financial
information about a specific reporting entity.
The relevance of information is affected by its materiality.
An error which is too trivial to affect a user’s understanding
of financial statement is referred to as immaterial.
– Materiality depends on the size and nature of the item
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Example
Small payments such as postage, stationery and cleaning
expenses should not be disclosed separately. They should be
grouped together as sundry expenses
The cost of small-valued assets such as pencil sharpeners and
paper clips should be written off to the profit and loss account
as revenue expenditures, although they can last for more than
one accounting period
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Materiality:
30
Substance over form
Meaning
financial information must account for transactions and other events in a way
that reflects their substance and economic reality (in other words, their true
commercial impact) rather than their legal form.
If there is a difference between economic substance and legal form, the
financial information should represent the economic substance.
Company A is essentially an agent for Company B, and so should only record a
sale on behalf of Company B in the amount of the related commission.
However, Company A wants its sales to appear larger, so it records the entire
amount of a sale as revenue.
Company D creates bill and hold paperwork to legitimize the sale of goods to
customers where the goods have not yet left the premises of Company D.
Leased asset
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Completeness
Meaning
The objective of financial reporting is to provide useful
information. Information is only useful if a person can
rely on it.
To be reliable, information should be complete,
subject to materiality and cost. (There is no need to
include information if it is not material, and greater
accuracy is not required if the cost of obtaining the extra
information is more than the benefits that the
information will provide to its users).
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Completeness
A company rents office space at a cost of Rs. 6,000,000 per
year paid 12 months in arrears (this means that the company
pay the rent at the end of the year). The first payment is due
on 30 June Year 2. The company prepares its financial
statements to 31 December each year. The company will not
have received an invoice for the rent when it is preparing its
financial statements for 31 December Year 1 If the company
does not accrue for the expense that relates to the 6 months
to 31December year 1 the information would be incomplete.
33
Objectivity
Meaning
The accounting information should be free from bias and
capable of independent verification
The information should be based upon verifiable evidence such
as invoices or contracts
34
Example
The recognition of revenue should be based on verifiable
evidence such as the delivery of goods or the issue of invoices
35
Consistency
Meaning
The content of the financial statements must be presented
consistently from one period to the next.
– Companies should choose the most suitable accounting
methods and treatments, and consistently apply them in every
period
– Changes are permitted only when the new method is
considered better and can reflect the true and fair view of the
financial position of the company
– The change and its effect on profits should be disclosed in the
financial statements
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Examples
If a company adopts straight line method and should not be
changed to adopt reducing balance method in other period
If a company adopts weight-average method as stock valuation
and should not be changed to other method e.g. first-in-first-
out method
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Accruals/Matching
Meaning
Record the transaction irrespective of receipt and payment
of cash.
– Revenues are recognized when they are earned, but not when
cash is received
– Expenses are recognized as they are incurred, but not when
cash is paid
– The net income for the period is determined by subtracting
expenses incurred from revenues earned
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Accruals basis
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Accruals
1. Accrued Revenues — Revenues earned but not yet
received in cash or recorded.
2. Accrued Expenses — Expenses incurred but not
yet paid in cash or recorded.
Prepayments
1. Prepaid Expenses — Expenses paid in cash and
recorded as assets before they are used or
consumed.
2. Unearned Revenues — Revenues received in cash
and recorded as liabilities before they are earned.
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Accrual Basis: Prepayment
A company starts in business on 1 September Year 1.
It acquires an office for which it pays one year’s rent in advance, to
31 August Year 2.The cost of the annual rental is Rs. 120,000. The
company prepares its financial statements for a financial period
ending on 31 December each year.
The office rental cost in the period to 31 December Year 1 is the cost
of just four months’ rent.
The expense is therefore Rs. 40,000 (Rs. 120,000 * 4/12) in
Year 1, and
there has been a prepayment for Rs. 80,000 that relates to the
next financial period, the year to 31 December Year 2.
41
A company rents office space at a cost of Rs. 6,000,000 per year paid
12 months in arrears (this means that the company pay the rent at the
end of the year). The first payment is due on 30 June Year 2.
The company prepares its financial statements to 31 December each
year.
The company will not have received an invoice for the rent when it is
preparing its financial statements for 31 December Year 1.
However, it knows that it has occupied the office space for six months.
The company would recognise a liability for rental costs for six months (Rs.
3,000,000) and also include this as an expense in profit and loss for Year 1.
This is described as accruing an expense or making an accrual.
42
Disclosure
Meaning
Financial statements should be prepared to reflect a true and
fair view of the financial position and performance of the
enterprise
All material and relevant information must be disclosed in the
financial statements
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True and fair view
Meaning
financial statements should provide a faithful
representation of all affairs of the company.
A perfectly faithful representation would have three characteristics. It
would be:
complete - the depiction includes all information necessary for a
user to understand the phenomenon being depicted, including all
necessary descriptions and explanations.
neutral /objective- the depiction is without bias in the selection or
presentation of financial information; and
free from error - where there are no errors or omissions in the
description of the phenomenon, and the process used to produce the
reported information has been selected and applied with no errors in
the process.
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Question No-1: (Spring-17)
Following principles are used by ABC Enterprises for preparation of its financial statements:
a) Fixed assets are stated at cost less accumulated depreciation.
b) Items of capital nature, costing less than Rs. 1,000 are charged to cost.
c) Stock-in-trade is valued on the same basis as is being followed for last
many years.
d) Appropriate provision is made for bad and doubtful debts.
e) Sales revenue is recorded on dispatch of goods to customers irrespective
of the date of receipt of payment.
f) Cost of sales is recorded in the same period in which the revenue earned
from the sale is recorded.
Required: Identify and explain the above accounting concepts/principles being followed by ABC
Enterprises for preparation of its financial statements.
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Question No-2: (Autumn-16)
Consider the following situations:
a) Due to heavy losses during the current year, Quality Traders (QT)
decided to discontinue its operations with effect from 1 August 2016.
However, QT’s financial statements for the year ended 30 June 2016
were prepared using the same basis as last year.
b) Results of Shan Enterprises (SE) fluctuate widely from year to year.
Therefore, SE’s management has decided to create certain provisions in
the periods of higher profits and adjust those provisions in the period of
lesser profits to maintain profits at a consistent level from year to year.
Required:
Identify and explain the accounting concept/principle relevant to each of the above situations. (04)
Suggest adjustments, if any, to correct the financial statements for the year ended 30 June 2016. (02)
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Question No-5: (Autumn-15)
While preparing the financial statements, you are faced with the following situations:
1. The future existence of the company is uncertain.
2. The credit cards bills of the proprietor were paid and charged to the business.
3. Property, plant and equipment now costs more than the price at which it was purchased
at the inception of business. However, the current prices are not reflected in the
financial statements.
4. During the year, the company purchased stationery worth Rs. 30,000. The amount has
been charged to office supplies consumed, however major portion of the stationery was
consumed after year-end.
5. The company had a poor trading year and the owners have decided to adopt weighted
average valuation method instead of FIFO.
6. Leased equipment have been recorded as assets although these are not owned by the
organization.
Required: State the accounting concept that has been applied or needs to be considered in
each of the above situations. (06)
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Question No-6: (Autumn-15)
Explain the term ‘business transaction’ and discuss whether you would consider the following
events as business transactions:
1. A businessman purchased a vehicle for his private use by drawing cash from business.
However, he also uses it for coming to the office.
2. ABC & Company has paid the electricity bill of one of its partners. However, the
amount is recoverable from that partner.
3. Furniture and fixtures lying in the office were destroyed by fire. Furniture was owned
by one of the partner and it was not in the use of business.
4. The proprietor provides a generator to the office. The generator is presently not
working and it would have to be repaired before it can be used. Previously the generator
was lying in the proprietor’s house.
5. Balance recoverable from an employee was written off after his death. (09)
Question No-7: (Spring-15)
Briefly describe the concept of ‘Substance over form’. Give two examples. (04)
Big Traders, who is a multi-million rupees trading house, purchased a calculator for Rs.
1,500. The calculator is to be used for 3 years. Keeping in view the relevant accounting
concepts, describe the accounting treatment of the above transaction. (03)
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Question No-8: (Spring-15)
Mr. Karobari is a sole proprietor and is engaged in the business of selling plastic bottles to hospitals
and dispensaries. Following two transactions were recorded in the month of February 2015:
Goods worth Rs. 57,000 were returned to a credit supplier.
A cheque for Rs. 15,000 was drawn for cash.
Required:
(i) Identify the source document and the subsidiary book used for each of the above two transactions.
(02)
(ii) Prepare journal entries to record the above two transactions. (02)
(iii) Assuming the goods returned to the supplier in transaction 1 above had been wrongly entered as
Rs. 75,000 in the subsidiary book, identify the type of error and its possible effect(s) on the
accounting records and financial statements of Mr. Karobari. (06)
Question No-9 (Spring-15)
Explain the following accounting terms: A) Prepayment B) Accrued expense (03)
Question No-10: (Spring-15)
What are the two main purposes of a trial balance? (02)
Briefly describe the primary reason for issuance of various documents used in a system designed to
account for sales. (06)
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Question No-11: (Autumn-14)
Name the accounting concepts/principles on which the following rules are based.
1. Nothing material is left out that would be vital to investors or other users in assessing the
underlying events and conditions of the business.
2. Whether the item in question affects decision of the users of the financial statements?
3. A company is separate and distinct from its owners.
4. Financial information must not only represent relevant phenomena but it must also be complete,
neutral and free from error.
5. Expenses incurred in a particular time period should be compared with the revenue earned during
the same time period.
6. Caution should be exercised while preparing financial statements in order to avoid overstatement
of net assets and net income.
7. The assumption that a business entity will continue in existence for the foreseeable future.
8. Same accounting policy shall be applied to accounting events from period to period. (08)
Question No-12: (Autumn-14)
What is meant by Chart of Accounts? Explain the purpose of creating a chart of accounts. (04)
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Answer Q No-2:
(i)
(a) Accounting concept that effects preparation of QT's financial
statements for the year ended 30 June 2016 is 'going
concern'.This means that financial statements are prepared on the
assumption that the entity will continue to operate for the
foreseeable future and does not intend to go into nor will be forced
into liquidation.
(b) After QT's decision to discontinue its operations, QT is no more a
going concern. Therefore, as at 30 June 2016, its assets and
liabilities should be valued at their estimated disposal value.
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(ii)
(a) Accounting concept pertaining to this situation is 'true and fair
view' (faithful representation).
According to this concept, financial statements should give true
and fair view/faithful representation of the financial position,
financial performance, and changes in financial position of an
entity.
(b) Making provisions just to even out the profits is against the
true and fair view/faithful representation and should be
avoided. Therefore, any provisions made on this basis should be
reversed immediately.
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ANS Q 3
User Groups and information that would be of interest to them:
a) Investors require information to assess the ability of an entity to earn profits and to
pay dividends. Principally, they need to decide whether to buy, hold or sell shares.
b) Employees and their representative groups (e.g. trade unions), require information
to assess the ability of an entity to provide remuneration, retirement benefits and
employment opportunities.
c) Lenders are interested in information that enable them to determine whether their
loans and interest entitlements will be paid when due.
d) Suppliers require information which will enable them to assess whether the entity
has the ability to pay amounts owed when they fall due.
e) Customers are interested in assessing the continuance of an entity where they have a
longterm involvement with them and/or are dependent on them for supplies.
f) Government and their agencies require information for a variety of purposes. These
include resource allocation decisions (e.g. government grants), to assess taxable
capacity and for regional and national planning purposes.
g) Public is interested in variety of ways which include employment potential,
Corporate Social Responsibility (CSR) activities and for environment assessment
purposes.
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Answer Q No-4:
a) Payment of creditors by bank overdraft
b) Purchase of machine against cash
c) Creditors paid through bank
d) Cash withdrawal by the proprietor
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Answer No-5:
1. Going concern
2. Business entity
3. Historical cost
4. Materiality/Matching/ Accrual
5. Consistency
6. Substance over form
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Answer No-6:
Business Transactions: A business transaction is an interaction between a business and
customer, supplier or any other party with whom they do business. It is an economic
event that must be recorded in the business’s accounting system.
I. A businessman leases vehicle from a bank: Purchase of a vehicle is not a business
transaction. However, the cash withdrawal is a business transaction.
II. ABC and Company has paid the electricity bill of one of its partners: Payment on behalf
of the partner is recoverable by the business. Hence this is a business transaction.
III. Furniture and fixtures owned by a partner but lying in the office were destroyed by
fire: It is not a business transaction as the ownership of furniture do not lies with the
business entity but to one of the partner.
IV. The proprietor provides a generator to the office. The generator was previously lying in the house
of the proprietor: It is a business transaction and it is required to be recorded as capital invested
in business in the form of generator.
An amount recoverable from an employee was written off after his death: This is a business
transaction as the employee was working for the business and such waiver is a form of benefit to the
employee.
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Answer No-7:
(a) Substance over form:
It is an accounting principle that transactions and other events must be accounted for and
presented according to their substance and financial / economic reality instead of
according to their legal form.
Example 1: Leased assets:
In a financial lease, the lessor obtains title to the assets only at the end of the lease.
However, the substance of the transaction is that the lessor obtains use of the asset from
the outset of the lease. Thus, we treat the asset as if it was purchased outright at the start.
Example 2: Sale and lease-back agreements:
In such agreements there is a legal form of sale with one party having the right to buy the
goods back and the other party to sell back. However in substance, there is a loan by one
party to another and so it is recorded.
Example 3: Accounting for groups:
Although the parent and subsidiaries are separate legal entities, the group is effectively a single
operating unit and under the substance over form concept, a single set of accounts is prepared
known as consolidated accounts.
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(b)
The matching concept directs the Big Traders to expense the cost
of the calculator over the period of three years i.e. Rs. 500 per
year. However, in view of the materiality concept, Big Traders
may expense the entire cost of Rs. 1,500 in the year of purchase
as this transaction would not render the financial statement
misleading.
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Answer Q No-8:
59
(iii) Type of error and its possible effect(s):
Type of error:
It is an error of original entry OR transposition error.
Possible effects may include:
(net) purchases/cost of sales will be understated.
Returns outwards/purchases returns will be overstated.
Supplier/trade payable’s/purchases ledger control account in
purchases ledger will be understated.
Gross profit/profit for the year will be overstated.
Trade payables/current liabilities will be understated.
Net assets/net current assets/capital will be overstated.
Balance sheet will not show a true and fair view.
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Answer No-9:
(i) Prepayment:
A prepayment is the amount of money paid in advance for benefits
that will be received in the next accounting period.
(ii) Accrued expense:
An accrual or accrued expense is an amount that an entity owes in
respect of a benefit it has received in a period but for which it has
not yet been invoiced or which has not yet been paid.
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Answer No-10:
(a) Purposes of a trial balance:
Following are the two main purposes of a trial balance:
(i) It is a starting point for producing a statement of comprehensive
income and a statement of financial position at the end of an
accounting period.
(ii) It is a useful means of checking arithmetical errors in the
accounting system. Error must have occurred if the totals of debit
and credit balances are not equal.
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Answer No-11:
Chart of accounts (COA) is a list of accounts created by a business to be used
to organise its financial transactions into identified categories of assets,
liabilities, equity, income and expenses.
The main purpose of creating the chart of accounts are as follows:
COA forms the framework for summarizing business operations and to segregate
assets, liabilities, income and expenses.
Each account is identified by a unique code and heading. This allows a business to
generate instructions and policies to be followed by the staff responsible for recording
information.
The list is typically arranged in the order of the customary appearance of accounts in
the financial statements. The structure and headings in the list brings consistency in the
posting of transactions.
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