Chapter10Accounting concepts and assumptions
After you have studied this chapter, you should be able to:Describe the assumptions which are made when recording accountingdataExplain why one set of financial statements has to serve manypurposesExplain the implications of objectivity and subjectivity in the context ofaccounting
Explain what accounting standards are and why theyexistExplain the underlying concepts ofaccountingExplain how the concepts and assumptions of materiality, going concern, comparability through consistency, prudence, accruals, separate determination, substance over form and other concepts and assumptions affect the recording and adjustment of accounting data and the reporting of accountinginformation
Objective of financial statements
Financial statements should provide information about the financial position, performance and changes in the finances of anentity.Financial statements should be useful to a wide range of users in making economicdecisions.Financial statements are prepared on the basis of established concepts and must adhere to the rules and procedures set down in regulations, called accountingstandards.
Financial accounting seeks objectivity and consistency in the preparation and presentation ofinformation.To achieve objectivity, a set of fundamental rules have been devised, laying down the way transactions arerecorded.These rules are known as accounting concepts and are enforced by their incorporation in accounting standardsissued.
Concepts – Historical cost
The historical cost concept requires that assets are normally shown at costprice.Cost price is the basis for valuation of theassets.
Concepts – Money measurement
The money measurement concept requires that accounting information is traditionally only concerned with facts that:(a) Canbe measured in monetaryunits.(b)Mostpeople will agree to the monetary value of thetransaction.
Concepts – Business entity
The business entity concept implied that the affairs of a business are to be treated as being quite separate from the non-business activities of its owner(s).Therefore, items recorded in the books of the business are restricted to the transactions of thebusiness.
Concepts – Dual aspect
The dual aspect concept states that there are two aspects of accounting – one represented by the assets of the business and the other by the claims againstthem.This concept can be summarised by a form of the accounting equation:
Concepts – Time interval
Thetime interval concept requires that an entity will prepare financial statements at regular intervals during theyear.
The accruals concept states that the effects of transaction and other events are recognised when they occur and they are recorded in the books and reported in the financial statements of the period to which theyrelate.This allows income and charges relating to the period to be taken into account by matching the income with theexpenditure.
Concepts – Going concern
The going concern concept assumes that the business will continue to operate for at least 12 months after the end of the reportingperiod.This concept should only be ignored if the business is going to close down in the near future, or if a shortage of cash makes it likely that the business will ceasetrading.
Qualitative characteristicsof financial statements
There are four principal qualitative characteristics:UnderstandabilityRelevanceReliabilityComparability
The quality of understandability
Informationin financial statementsshould be readily understandable byusers.
The quality of relevance
Information in financial statements must be relevant to users and influence their economicdecisionsThat which ismaterialis relevant and should be included.Informationis material if its omission or misstatement could influence the economic decisions ofusers
The quality of reliability
The information in the financial statements must be reliable – free from error and bias, and able to be depended upon:It must be a faithful representation oftransactions.Transactions must be accounted for and presented in accordance with their substance, not their legalform.Information must be free frombias.A degree of caution should be exercised when makingestimates.The information must becomplete.
The quality of comparability
The measurement and display of the financial effect of similar transactions and other events must be done in a consistent way throughout an entity and over time for that entity, and in a consistent way for differententities.Users must be informed of accounting policies used and anychanges.Financial statements must include corresponding information for precedingperiods.
Constraints on relevantand reliable information
Information must be reported in a timelymanner.The benefits of information should exceed the costs of obtainingit.The aim should be to achieve a balance among the characteristics that best meets the objective of financialstatements.
You should have nowlearnt:Why one set of financial statements has to serve manypurposesWhy the need for general agreement has given rise to the concepts and conventions that governaccountingThe implications of objectivity and subjectivity in the context ofaccounting
Whataccounting standards are and why theyexistThe assumptions which are made when recording accountingdataThe underlying concepts ofaccounting
How the concepts and assumptions of materiality, going concern, comparability through consistency, prudence, accruals, separate determination, substance over form, and other concepts and assumptions affect the recording and adjustment of accounting data and the reporting of accountinginformationThat an assumption is made that monetary measures remain stable,that isthat accounts are not normally adjusted for inflation ordeflation