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Lecture 3
Accounting assumptions and concepts
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Welcome
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Todays quote
Genius is one per cent inspiration andninety-nine per cent perspiration- byThomas Edison
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Specific Objectives
Students should be able to
1.Explain the definition of accounting
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Accounting Definition
The process of
accumulating,
analyzing,
quantifying,classifying,
recording,
summarizing,
Interpreting and reporting data relating to the
economic resources of an enterprise to all
interested parties
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Accounting Concepts
Accounting principles are built on the foundation of anumber of basic concepts that accountants regard as
self evident
When such concepts are followed unquestionably forgenerations they are called conventions
In order to understand accounting as it now exists,
one must understand what the underlying concepts,
assumptions and principles areThese concepts , assumptions and principles
called Generally Accepted Accounting
Principles)GAAP
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Accounting ConceptsAccrual Basis-
Also known as the Matching Concept
The effects of transactions and other events are
recognized in the accounts when they occur and not
when the cash or its equivalent is received or paid.
It means that revenue must be matched the costs,
expenses incurred against earning .
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Historical Cost Concept
The assets are normally shown at cost price and it is thebasis for valuation of the assets.
In other words, all values are based on the historical costs
incurred
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Historical Cost continued
There are exceptions such as inventories of finishedgoods, raw materials and market securities whichare shown in the balance sheet at cost or netrealizable value whichever is lower.
This implies that there are two aspects ofaccounting, one represented by the assets of thebusiness and the other by the liabilities or claimsagainst them. The concept states that these twoaspects are always equal to each other.
In other words, this is the alternate form of theaccounting equation; Assets = Capital + Liabilities
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Going concern concept-
The financial statements of an enterprise are preparedon the assumption that it will continue in operation for
the foreseeable future.
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Example- Going Concern
Let us suppose, a business is preparing itsfinancial statements at 31st December 2008.
Normally, historical using the cost concept, theassets would be shown at a total value of$100,000.
It is known that the business will be forced toclose down in February 2009, only two monthslater and the assets are expected to be sold for$60,000.
In this case, it would not make sense to keep tothe going concern concept and so we can rejectthe historical cost concept for asset valuationpurposes.
In the Balance sheet at 31st
December 2008, theassets will be shown at the fi ure of $60 000
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The business entity concept
It implies that the affairs of a business are
treated separate from the non businessactivities of its owners.
The items recorded in the books of the
business are restricted or limited to thetransactions of the business.
Example, owner starts business with $500,000,
the owner becomes a long term creditor of thebusiness, in other words the business owes the
owner $500,000.
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The money measurement conceptAccounting information has traditionally
been concerned only with those facts coveredby the following:
It can be measured in monetary units
Most people will agree to the monetary valueof the transaction
This limitation is referred to as the
monetary measurement concept and itmeans that accounting can never explain
everything about a business
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The Time Interval or Period concept
The financial statements are prepared at
regular intervals of one year.
Companies which publish financialstatements between their annual ones arecalled interim statements
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Realization concept
It states that revenues should be recorded inthe period when the goods are delivered to the
customer or when the services are rendered
Amount recognized is the amount that the
customer has a legal obligation to pay
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Prudence
This is the inclusion of a degree of caution inthe exercise of the judgment needed in makingestimates required under conditions ofuncertainty so that assets and income are notoverstated and liabilities and expenses are notunderstated.
Accountant should always exercise cautionwhen dealing with uncertainty while at the sametime ensuring that the financial statements areneutral - gains and losses are neither
overstated nor understatedRevenue are recognized only when they are
reasonably certain, whereas expenses arerecognized as soon as they can bereasonably estimated
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Qualitative Characteristics of FinancialStatements
There are four (4) qualitative characteristics
known understandability, relevance,
reliability and comparability
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1.Understandability-
Information in financialstatements should bereadily understandable by
users
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(2)Relevance-
Information in financialstatements must be relevant to thedecision making needs of users.
To be relevant, information mustinfluence the economic decisionsof users by assisting them toevaluate past, present or future orconfirming or correcting their past
evaluation
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(3) Materiality-Information is material if its omission
or misstatement could influence theeconomic decisions of users.
Material if its disclosure is likely to leadthe users of the accounting informationto act differently or to come to adifferent conclusion if it were notdisclosed
Materiality depends on the size of the
item or error judged in the particularcircumstances of its omission ormisstatement
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(4) Reliability
To be useful informationshould be on the following-
1. Faithful representation aBalance Sheet should representfaithfully the transactions and other
events that result in assets, liabilitiesand equity of the entity at thereporting date.
S b t f
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Substance over form-
Definition
Transactions and other events must beaccounted for and presented in accordance
with their substance and economic realityand not merely their legal form.
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Example- I will be using a hire purchase transaction in respect to a non
current asset, car, to illustrate this condition. What is hire purchase? Use Stewarts Motor Ltd - car
1. From a legal point of view, the car does not belong to thebusiness until all installments are made that is only when the
final payment is made2. From an economic point of view, business will have used the
car for business purposes. The car bought on hire purchasewill be shown in its ledger accounts and balance sheet, as anon current asset, as though it is legally owned by the business
as well as a liability showing separately the amount owed forthe car.
3. In this way, the substance of the transaction has takenprecedence over the legal form of the transaction
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NeutralityInformation in financialstatements must be free of bias
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Prudence (Conservatism) This is the inclusion of a degree of caution in
the exercise of the judgment needed in
making the estimates required under
conditions of uncertainty such that assets and
income are not overstated and liabilities andexpenses are not understated.
Accountant should always exercise caution
when dealing with uncertainty while at thesame time ensuring that the financial
statements are neutral that gains and losses are
neither overstated nor understated
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Jamaica scenario
Do you think with we are living in a time ofuncertainty?
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Completeness- To be reliable, information infinancial statements must be complete withinthe bounds of materiality and cost
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Comparability-
To be reliable, comparability requires
consistency. Users must be able to compare the financial
statements of an enterprise over time to
identify trends in the financial position andperformance
The measurement and display of the financial
effect of similar transactions and other eventsmust be done in a consistent way throughout
an entity and over time for the entity as well as
for other entities.
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Asset-
A resource controlled by the entity as a
result of past events and from which futureeconomic benefits are expected to flow tothe enterprise.
Examples- Building, Plant,Machineryknown as non current assets
Current assets assets that used for the
trading purposes of a business Examples- inventory, debtors, cash
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Liability- Non current liabilities andcurrent liabilities
1.An entitys present obligation arising as aresult of past transactions or events.
2.Examples- Bank Loan over one year or 12months known non current liability
Current Liabilities
1.Liabilities to be settled within 12 months2.Examples- bank overdraft, creditors
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Equity- known as CAPITAL
The residual interest in the assets afterdeducting all liabilities from TotalAssets.
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Students -Reflection on todays lesson
Summary of the days lesson
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Next week lecture
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Read Chapters 1 and 10, Frank Wood
Business Accounting Text Book, eleventhedition
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THE END