Accounting Concepts and Principles

are a set of broad conventions that have been devised to provide a basic framework for
financial reporting.
Financial reporting involves significant professional judgments, these concepts and principles
ensure that the users of financial information are not mislead by the adoption of accounting
policies and practices that go against the spirit of the accountancy profession.
Accountants must therefore actively consider whether the accounting treatments adopted are
consistent with the accounting concepts and principles.
In order to ensure application of the accounting concepts and principles, major accounting
standard-setting bodies have incorporated them into their reporting frameworks such as the
IASB Framework.
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.
Example:
A company discloses an increase in Earnings Per Share (EPS) from $5 to $6 since the last
reporting period. The information is relevant to investors as it may assist them in confirming
their past predictions regarding the profitability of the company and will also help them in
forecasting future trend in the earnings of the company.
Relevance is affected by the materiality of information contained in the financial statements
because only material information influences the economic decisions of its users.
Example:
A default by a customer who owes $1000 to a company having net assets of worth $10 million
is not relevant to the decision-making needs of users of the financial statements.
However, if the amount of default is, say, $2 million, the information becomes relevant to the
users as it may affect their view regarding the financial performance and position of the
company.
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
Accruals Concept
Financial statements are prepared under the Accruals Concept of accounting which requires
that income and expense must be recognized in the accounting periods to which they relate
rather than on cash basis.
An exception to this general rule is the cash flow statement whose main purpose is to present
the cash flow effects of transaction during an accounting period.
Under Accruals basis of accounting, income must be recorded in the accounting period in which
it is earned.
Therefore, accrued income must be recognized in the accounting period in which it arises
rather than in the subsequent period in which it will be received.
Conversely, prepaid income must be not be shown as income in the accounting period in which
it is received but instead it must be presented as such in the subsequent accounting periods in
which the services or obligations in respect of the prepaid income have been performed.
Expenses, on the other hand, must be recorded in the accounting period in which they are
incurred.
Therefore, accrued expense must be recognized in the accounting period in which it occurs
rather than in the following period in which it will be paid.
Conversely, prepaid expense must be not be shown as expense in the accounting period in
which it is paid but instead it must be presented as such in the subsequent accounting periods
in which the services in respect of the prepaid expense have been performed.
Accruals basis of accounting ensures that expenses are "matched" with the revenue earned in
an accounting period. Accruals concept is therefore very similar to the matching principle.
Dual Aspect Concept | Duality Principle in Accounting
1. Definition
Dual Aspect Concept, also known as Duality Principle, is a fundamental convention of
accounting that necessitates the recognition of all aspects of an accounting transaction. Dual
aspect concept is the underlying basis for double entry accounting system.
2. Explanation
In a single-entry system, only one aspect of a transaction is recognized. For instance, if a sale is
made to a customer, only sales revenue will be recorded. However, the other side of the
transaction relating to the receipt of cash or the grant of credit to the customer is not
recognized.
Single entry accounting system has been superseded by double entry accounting. You may still
find limited use of single-entry accounting system by individuals and small organizations that
keep an informal record of receipts and payments.
Double entry accounting system is based on the duality principle and was devised to account
for all aspects of a transaction. Under the system, aspects of transactions are classified under
two main types:
1. Debit 2. Credit
Debit is the portion of transaction that accounts for the increase in assets and expenses, and
the decrease in liabilities, equity and income.
Credit is the portion of transaction that accounts for the increase
in income, liabilities and equity, and the decrease in assets and expenses.
The classification of debit and credit effects is structured in such a way that for each debit there
is a corresponding credit and vice versa. Hence, every transaction will have 'dual' effects (i.e.
debit effects and credit effects).
The application of duality principle therefore ensures that all aspects of a transaction are
accounted for in the financial statements.
3. Example
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 2,000
2. Sale of books for cash 5,000
3. Sales of books on credit 15,000
4. Receipts from credit customers 10,000
5. Purchase of books for cash 20,000
6. Utility expenses - unpaid 3,000
Under double entry system, the above transactions will be accounted for as follows:
Account Title Effect Debit Credit
$ $
1. Salary Expense Increase in expense 2,000
Cash at bank Decrease in assets 2,000
2. Cash in hand Increase in assets 5,000
Sales revenue Increase in income 5,000
3. Receivables Increase in assets 15,000
Sales revenue Decrease in income 15,000
4. Cash at bank Increase in asset 10,000
Receivables Decrease in asset 10,000
5. Purchases Increase in expense 20,000
Cash at bank Decrease in asset 20,000
6. Utility Expense Increase in expense 3,000
Accrued expenses Decrease in asset 3,000
What is a Going Concern?
Going concern is one the fundamental assumptions in accounting on the basis of which financial
statements are prepared. Financial statements are prepared assuming that a business entity
will continue to operate in the foreseeable future without the need or intention on the part of
management to liquidate the entity or to significantly curtail its operational activities.
Therefore, it is assumed that the entity will realize its assets and settle its obligations in the
normal course of the business.
It is the responsibility of the management of a company to determine whether the going
concern assumption is appropriate in the preparation of financial statements. If the going
concern assumption is considered by the management to be invalid, the financial statements of
the entity would need to be prepared on break up basis. This means that assets will be
recognized at amount which is expected to be realized from its sale (net of selling costs) rather
than from its continuing use in the ordinary course of the business. Assets are valued for their
individual worth rather than their value as a combined unit. Liabilities shall be recognized at
amounts that are likely to be settled.
What are possible indications of going concern problems?
 Deteriorating liquidity position of a company not backed by sufficient financing
arrangements.
 High financial risk arising from increased gearing level rendering the company
vulnerable to delays in payment of interest and loan principle.
  Significant trading losses being 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.
 Bankruptcy of a major customer of the company.

Business Entity Concept

Financial accounting is based on the premise that the transactions and balances of a business
entity are to be accounted for separately from its owners. The business entity is therefore
considered to be distinct from its owners for the purpose of accounting.
Therefore, any personal expenses incurred by owners of a business will not appear in the
income statement of the entity. Similarly, if any personal expenses of owners are paid out of
assets of the entity, it would be considered to be drawings for the purpose of accounting much
in the same way as cash drawings.
The business entity concept also explains why owners' equity appears on the liability side of a
balance sheet (i.e. credit side). Share capital contributed by a sole trader to his business, for
instance, represents a form of liability (known as equity) of the 'business' that is owed to its
owner which is why it is presented on the credit side of the balance sheet.

A Trial Balance
- is a list of closing balances of ledger accounts on a certain date and is the first step
towards the preparation of financial statements.
- It is usually prepared at the end of an accounting period to assist in the drafting of
financial statements.
- Ledger balances are segregated into debit balances and credit balances.
- Asset and expense accounts appear on the debit side of the trial balance whereas
liabilities, capital and income accounts appear on the credit side.
- If all accounting entries are recorded correctly and all the ledger balances are
accurately extracted, the total of all debit balances appearing in the trial balance
must equal to the sum of all credit balances.
Purpose of a Trial Balance
 Trial Balance acts as the first step in the preparation of financial statements. It is a
working paper that accountants use as a basis while preparing financial statements.
 Trial balance ensures that for every debit entry recorded, a corresponding credit entry
has been recorded in the books in accordance with the double entry concept of
accounting. If the totals of the trial balance do not agree, the differences may be
investigated and resolved before financial statements are prepared. Rectifying basic
accounting errors can be a much lengthy task after the financial statements have been
prepared because of the changes that would be required to correct the financial
statements.
 Trial balance ensures that the account balances are accurately extracted from
accounting ledgers.
 Trail balance assists in the identification and rectification of errors.

Example
Following is an example of what a simple Trial Balance looks like:

ABC LTD
Trial Balance as at 31 December 2011

Debit Credit
Account Title
$ $

Share Capital 15,000

Furniture & Fixture 5,000

Building 10,000
 Creditor 5,000

Debtors 3,000

Cash 2,000

Sales 10,000

Cost of sales 8,000

General and Administration Expense 2,000

Total 30,000 30,000

1. Title provided at the top shows the name of the entity and accounting period end for
which the trial balance has been prepared.
2. Account Title shows the name of the accounting ledgers from which the balances have
been extracted.
3. Balances relating to assets and expenses are presented in the left column (debit side)
whereas those relating to liabilities, income and equity are shown on the right column
(credit side).
4. The sum of all debit and credit balances are shown at the bottom of their respective
columns.
Limitations of a trial balance
Trial Balance only confirms that the total of all debit balances match the total of all credit
balances.
Trial balance totals may agree despite errors. An example would be an incorrect debit entry
being offset by an equal credit entry.
Likewise, a trial balance gives no proof that certain transactions have not been recorded at all
because in such case, both debit and credit sides of a transaction would be omitted causing the
trial balance totals to still agree. Types of accounting errors and their effect on trial balance are
more fully discussed in the section on Suspense Accounts.

Accounting errors 
- is a notion used in financial reporting in order to describe a non-fraudulent discrepancy in the
financial documents of a company.
Types of accounting errors
There may be different types of errors:

 Error of omission: a financial transaction that does not appear in the documentation or
is not recorded by mistake, failing to record the item altogether.
  Error of commission: a recording of a transaction for the wrong value in the correct
account, such as subtracting a sum that should have been added.

 Error of principle: a financial transaction that does not meet the international
requirements and generally accepted accounting principles (GAAP). It appears as an
accounting mistake in which a figure is recorded in the incorrect account, thus violating
the fundamental principles of accounting. It is a procedural error which consists of the
correct value of the entry but placed incorrectly. These types of errors are also called
input errors.

 Transposition errors occur when two or more digits that are reversed (or transposed)
individually or as part of a larger sequence. It appears as an error in data entry when
posting a new recording. Although it is usually small and unintentional, it can result in
further miscalculations which can lead to significant financial losses, as well as time
invested in order to identify the problem.

 A “rounding error” is a mathematical miscalculation resulted by the modification of a

number to an integer or one with fewer decimals. Although usually it is inconsequential,
it may appear in some cases in the current computerized financial environment resulting
in a spiral cumulative effect, needing further resources in order to rectify it.

 Reversal of Entries – it may happen as accounting entries are completely reversed, thus
the entries are debited to one account and credited to the other.
Thus, by the consequences an error may have, they are:

 Simple errors in recording that do not impact the more general financial figures;

 Errors which may result in further miscalculations and would involve further scrutiny in
order to repair the damage.
By the intention of the person creating the issue, the errors may be:

 Non-intentional, as most input errors. In these cases, a more automatic system of checks
and balances is suggested in order to minimize the risk of such mistakes occurring in the
future.

 Intentional: a more delicate matter, these could lead to criminal investigation and
possible charges such as dilapidation or money laundering, therefore the intention
needs to be thoroughly and objectively assessed.
If a company discovers that an accounting error has been made and would have an important
financial consequence, it would involve resource to rectify the financial recordings as well as
issue a statement owning the fault and releasing the correct entries.