acct concepts hrb
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ACCOUNTING
Conceptual FrameworkAccounting Concepts and
Principles
Ch Hamad Rasool Bhullar
FCMA, FCIS, FPA, Mphil, M.Com, DCMA, PGD (Islamic Fin)
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Areas in AccountingProfession
Financial accounting
Cost accounting
Managerial accounting
Tax accounting
Auditing Accounting systems
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Importance of Framework
A conceptual framework underlyingfinancial accounting is important
because it can lead to consistentstandards and it prescribes thenature, function, and limits offinancial accounting and financialstatements.
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Introduction Actually there are a number of
accounting concepts, assumptions,conventions and principles basedon which we prepare our accounts
These generally acceptedaccountingprinciples(GAAPs) laydown accepted assumptions andguidelines and are commonly
referred to as accountingconcepts
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Users and Stakeholders of FS
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Users of Financial Statements Investors (Current and Potential)
Need information about the profitability, dividend yieldand price earnings ratio in order to assess the qualityand the price of shares of a company
Lenders (Bankers, Insurance Cos etc)
Need information about the profitability and solvency ofthe business in order to determine the risk and interestrate of loans
Management Need information for planning, policy making and
evaluation, for continuation and new projects
Suppliers and trade creditors Need information about the liquidity of business in order
to access the ability to repay the amounts owed to them
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Government Authorities and Planners Need information about various businesses for statistics
and formulation of economic plan
Customers and Consumers Interested in long-tem stability of the business and
continuance of the supply of particular products
Employees and Employees Union
Interested in the stability of the business to provideemployment, fringe benefits and promotion opportunities
General Public Need information about the trends and recent
development
Taxation Departments For assessments of right amount of taxes (Income Tax,
Excise, Customs, Sales Tax..etc)
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Limitations of conventional
financial statements Companies may use different
methods of valuation, cost calculationand recognizing profit
The balance sheet does not reflectthe true worth of the company
Financial statements can only showpartial information about thefinancial position of an enterprise,instead of the whole picture
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Accounting
ConceptsEnd of Confusion,Frustration, and
Failure
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Accounting Concepts
Business entity Money Measurement/stable
monetary unit
Going Concern Historical Cost Prudence/conservatism
Materiality
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Objectivity
Consistency Accruals/matching
Realization
Uniformity Full Disclosure
Relevance
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Business Entity
Meaning The business and its owner(s) are
two separate entities
Any private and personal incomesand expenses of the owner(s)should not be treated as theincomes and expenses of the
business Capital account reflects the
transactions with owners
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Examples Insurance premiums for the owners
house should be excluded from theexpense of the business
The owners property should not beincluded in the premises account of thebusiness
Any payments for the owners personalexpenses by the business will be treatedas drawings and reduced the ownerscapital contribution in the business
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Money Measurement Meaning
All transactions of the business arerecorded in terms of common unit of valuei.e. money
It provides a common unit of measurement,so such items which are not measurable inmoney are neithe recorded nor reported
Examples
Market conditions, technological changesand the efficiency of management wouldnot be disclosed in the accounts
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Going Concern Meaning
The business will continue in operationalexistence for the foreseeable future
Financial statements should be preparedon a going concern basis unlessmanagement either intends to liquidatethe enterprise or to cease trading, orhas no realistic alternative but to do so
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Example Possible losses form the closure of
business will not be anticipated in theaccounts
Prepayments, depreciation provisionsmay be carried forward in theexpectation of proper matching againstthe revenues of future periods
Fixed assets are recorded at historicalcost
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Historical Cost Meaning
Assets should be shown on the balancesheet at the cost of purchase instead of
current value Example
The cost of fixed assets is recorded atthe date of acquisition cost. The
acquisition cost includes all expendituremade to prepare the asset for itsintended use. It included the invoiceprice of the assets, freight charges,
insurance or installation costs
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Prudence/Conservatism
Meaning Revenues and profits are not anticipated.
Only realized profits with reasonablecertainty are recognized in the profit
and loss account However, provision is made for all known
expenses and losses whether the amountis 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 provision for doubtful debts should
be made Fixed assets must be depreciated over
their useful economic lives
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Materiality Meaning
Immaterial amounts may be aggregated
with the amounts of a similar nature orfunction and need not be presentedseparately
Materiality depends on the size and
nature of the item
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Example Small payments such as postage,
stationery and cleaning expenses shouldnot be disclosed separately. They should
be grouped together as sundry expenses The cost of small-valued assets such as
pencil sharpeners and paper clips shouldbe written off to the profit and loss
account as revenue expenditures,although they can last for more than oneaccounting period
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Objectivity Meaning
The accounting information should be
free from bias and capable ofindependent verification
The information should be based uponverifiable evidence such as invoices or
contracts
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Example The recognition of revenue should be
based on verifiable evidence such as thedelivery of goods or the issue ofinvoices
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Consistency Meaning Continuity from year toyear Companies should choose the most
suitable accounting methods andtreatments, and consistently apply themin every period
Changes are permitted only when the newmethod is considered better and can
reflect the true and fair view of thefinancial position of the company The change and its effect on profits
should be disclosed in the financial
statements
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Consistency
Examples If a company adopts straight line
method and should not be changed toadopt reducing balance method in otherperiod
If a company adopts weight-averagemethod as stock valuation and should
not be changed to other method e.g.first-in-first-out method
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Accruals/Matching
VsCash Basis of Accounting
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Accruals/Matching Meaning
Revenues are recognized when they areearned, 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 expensesincurred from revenues earned
Cash basis of Accounting fails to measurethe Economic performance of an Entity sogives Incomplete information
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Example
Expenses incurred but not yet paid incurrent period should be treated asaccruals/accrued expenses, so taken ascurrent liabilities
Expenses to be used in future periodsbut paid for in advanceshould betreated as prepaid expenses and takenas current assets
Depreciationshould be charged as partof the cost of a fixed asset consumedduring the period of use
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Problems in the
recognition of expenses Normally, expenses represents
resources consumed during the
current period. Some costs maybenefit several accounting periods,for example, developmentexpenditures, depreciation on fixedassets.
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Recognition criteria for
expenses Association between cause and effect
Expenses are recognized on the basis of adirect association between the expenses
incurred on the basis of a direct associationbetween the expenses incurred and revenuesearned out of the usage thereof
For example, the sales commissions should be
accounted for in the period when the productsare sold, not when they are paid
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Systematic allocation of costs When the cost benefit several accounting
periods, they should be recognized on the basisof a systematic and rational allocation method
For example, a provision for depreciationshould be made over the estimated useful lifeof a fixed asset
Immediate recognition If the expenses are expected to have no
certain future benefit or are even withoutfuture benefit, they should be written off inthe current accounting period, for example,stock losses, advertising expenses andresearch costs
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RealizationMeaning Revenues should be recognized when
the major economic activities havebeen completed Sales are recognized when the goods
are sold and delivered to customers
or services are rendered
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Recognition of revenue The realization concept develops rules forthe recognition of revenue
The concept provides that revenues are
recognized when it is earned, and not whenmoney is received A receipt in advance for the supply of
goods should be treated as prepaid incomeunder current liabilities
Since revenue is a principal component inthe measurement of profit, the timing ofits recognition has a direct effect on theprofit
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Recognition criteria for
revenues The uncertain profits should not beestimated, whereas reported profits mustbe verifiable
Revenue is recognized when1. The major earning process has substantially
been completed2. Further cost for the completion of the earning
process are very slight or can be accuratelyascertained, and
3. The buyer has admitted his liability to pay forthe goods or services provided and theultimate collection is relatively certain
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Example Goods sent to our customers on sale or
return basis This means the customer do not pay for
the goods until they confirm to buy. Ifthey do not buy, those goods will returnto us
Goods on the sale or returnbasis willnot be treated as normal sales andshould be included in the closing stockunless the sales have been confirmed bycustomers
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Problems in the
recognition of revenue Normally, revenue is recognized whenthere is a sale
The point of sales in the earning process is
selected as the most appropriated time torecord revenues However, if revenue is earned in a long and
continuous process, it is difficult todetermine the portion of revenue which isearned at each stage
Therefore, revenue is permitted to berecorded other than at the point of sales
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Exceptions to rule of salesrecognition1. Long-term contracts
Owning to the long duration of long-termcontracts, part of the total profit estimatedto have been arisen from the accounting
period should be included in the profit andloss account
2. Hire Purchase Sale Hire purchase sales have long collection
period. Revenue should be recognized whencash received rather than when the sale(transfer of ownership) is made
The interest charged on a hire purchase sale
constitutes the profit of transaction
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3. Receipts from subscriptions- A publisher receives subscriptions before itsends newspapers or magazines to itscustomers
- It is proper to defer revenue recognition untilthe service is rendered.
- However, part of subscription income can berecognized as it is received in order to matchagainst the advertising expenses incurred
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Full Disclosure Meaning Financial statements should be prepared
to reflect a true and fair view of the
financial position and performance ofthe enterprise
All material and relevant informationmust be disclosed in the financialstatements
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Uniformity Meaning
Different companies within the same
industry should adopt the sameaccounting methods and treatments forlike transactions
The practice enables inter-company
comparisons of their financial positions
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Relevance Meaning
Financial statements should be prepared
to meet the objectives of the users Relevant information which can satisfy
the needs of most users is selected andrecorded in the financial statement
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Integrity, Objectivityand Ethics of Reporting
The financial accounting and reportingfailures of BIG Companies like Enron,WorldCom, Tyco, Xerox etc shocked
the investors. The disclosure that someof the largest and best-knowncorporations had overstated profits
and misled investors, raised thequestion: Where were the Auditors?
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Accountancy is a
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Accountancy is aResponsible Profession
The shockwave led to: Global changes in regulations 2002
Prohibition on Non-Auditing serviceson Auditors and their firms
Penalties for the reporting ofmisleading financial statements
Restrictions on insider trading andInformation sharing
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Congratulations
For Learning with Patience