Accounting concepts
These concepts act as a framework for decision-making when specific accounting standards do not provide explicit guidance. For example, if a new type of asset is acquired, you must decide how to value it based on the Historic Cost or Realisation principles.
Key Implication: Any money taken out by the owner for personal use is recorded as Drawings, not as a business expense. This ensures that the profit figure reflects only the performance of the business, not the owner's lifestyle.
Incorrect Treatment: Recording this as 'Office Expenses' or 'Cost of Sales'. This would understate profit and overstate assets/liabilities incorrectly.
Correct Treatment: Record a Drawings entry. This reduces the owner's capital but does not affect the business's profit calculation, maintaining the separation between personal and business finances.
Correction: The Business Entity concept is an accounting principle, not necessarily a legal one. Even sole traders must treat their business finances separately from their personal finances in the books to calculate accurate profit.
Key Implication: Qualitative factors, such as the skill of employees, customer satisfaction, or brand reputation, are not recorded in the financial statements because they cannot be reliably measured in money. This is a significant limitation of traditional accounting.
Why examiners accept this: They are testing your understanding that accounting is quantitative. You must explicitly state that these items cannot be reliably measured in monetary terms.
Example Answer: 'Brand reputation is not recorded because it does not comply with the money measurement concept; its value cannot be objectively determined in currency.'
Key Implication: This provides an objective, verifiable basis for recording assets. For example, if land was bought for 100,000 ten years ago and is now worth500,000, it remains in the books at $100,000 (subject to depreciation or impairment rules).
Correction: Always use the historic cost (purchase price + any costs to bring it to working condition). Market value is only relevant for specific valuation methods like fair value accounting, which is not the default historic cost principle.
Key Implication: Assets are valued based on their continued use in the business (e.g., depreciated historic cost) rather than their immediate sale value. If the business is NOT a going concern, assets must be valued at their net realizable value (fire-sale price).
If Going Concern: The machine is kept in the Statement of Financial Position at 4,000 because it will continue to generate revenue for the business.</p> <p><strong>If Not Going Concern:</strong> The machine must be valued at what it can be sold for immediately (e.g.,2,500), as the assumption of continued use no longer applies.
Key Implication: This prevents profit manipulation by timing cash flows. For example, an expense incurred in December but paid in January is still recorded in December's accounts.
Scenario: Electricity bill of 1,200 covers the year ending 31 December. The bill is paid in January for the <em>next</em> year. At year-end,300 relates to the current year (January-March previous year? No, let's adjust).
Correct Scenario:
- Total annual electricity cost: 1,200.</li> <li>By 31 December, only 9 months have passed (900). The remaining 300 is for January of the next year.</li> <li><strong>Accrual (Prepayment):</strong> Record a <strong>Prepayment</strong> of300 in the Statement of Financial Position (Current Asset).
- Income Statement: Charge only $900 to the Profit or Loss account, even if cash paid was different.
Correction: Under accruals, you must adjust for accruals (expenses incurred but not paid) and prepayments (expenses paid in advance). The cash flow is irrelevant to the profit calculation for that period.
Key Implication: Provisions for doubtful debts and inventory write-downs are created to ensure profits are not inflated by potential future losses.
Why examiners accept this: They want to see the specific language of prudence: 'not overstating profits/assets' or 'anticipating losses'. Do not just say 'to be safe'.
Example Answer: 'A provision for doubtful debts is made in accordance with the prudence concept to ensure that assets (receivables) and profits are not overstated.'
Key Implication: For sales of goods, revenue is recorded at the point of sale (delivery), not when the invoice is sent or when payment is collected.
Correction: Revenue is realized when ownership and risk pass to the buyer. If goods are delivered in December but paid in January, the sale belongs in December's accounts.
Key Implication: If a business changes an accounting policy (e.g., from straight-line to reducing balance depreciation), it must disclose this change and its effect, but the primary goal is to avoid arbitrary changes that distort trends.
Why examiners accept this: They are looking for the link between consistency and comparability. Without consistent policies, users cannot determine if changes in profit are due to performance or accounting tricks.
Example Answer: 'Consistency ensures that financial statements are comparable over time, allowing users to identify trends in performance rather than changes in accounting methods.'
Key Implication: A $5 stapler might be expensed immediately rather than depreciated over 5 years because it is immaterial, even though technically it is a non-current asset.