Lecture 2 Accounting Concepts Conventions.pptx

accountig convention

1. Lecture-2 Accounting Concepts and Conventions

2. LEARNING OUTCOMES Appraise the accounting concepts used in preparation of financial statements. Recognize the accounting ethical issues of recording the financial transactions.

3. Poll Based on Previous Lecture Which of the following is not the business transaction? Bought furniture of Rs . 10,000 for business Paid son’s fees from personal bank account Rs . 50000 Paid salaries to employees Rs . 5500 Paid son’s fees from business Rs . 50000

4. Accounting Concepts

5. Why ACCOUNTING concepts are important? Accounting concepts are the basic assumptions, rules and principles. They Work as a basis of recording of business transactions and preparing accounts. They help in recording income and expenditures, confirm statutory compliance, and provide investors, management, and government with measurable financial information which can be utilized in making necessary business decisions.

6. Accounting Concept 1 Business Entity Concept Jack started an electronics business. For this purpose, he invested a sum of Rs . 500,000 into the business. Out of this Rs . 500,000, he bought: Electronic accessories worth Rs . 100,000. Furniture for setting the business office Rs . 250,000 Small machinery Rs . 50,000 The balance cash – in – hand available in the business was Rs . 100,000 At some later date, his own mobile was damaged, therefore, he took a new mobile phone from the business stock for his personal use.

7. Accounting Concept 1 Business Entity Concept Meaning:- Business entity and owner are two separate entities . Business transactions are recorded in business books of accounts Owner’s transactions are recorded in personal books of accounts

8. Accounting Concept 1 Business Entity Concept Effects of Business Entity Concept Owner’s capital = recorded as liability of the business Amount/goods withdrawn from business = recorded as drawings Owner’s personal transactions = not recorded in business books of accounts

9. Accounting Concept 2 Going Concern Concept Small Case A company purchased a plant and machinery of Rs.100000 and its life span is 10 years. In the absence of Going concern concept, how will you record it as- Fixed asset or, Expense?? It is assumed that the entity is a going concern, i.e., it will continue to operate for an indefinitely long period in future and transactions are recorded from this point of view.

10. Accounting Concept 2 Going Concern Concept Small Case Going = Continuing Concern = Business entity Business entity has neither intention nor necessity to shut down its’ operations in future. Business entity will carry its’ operations for indefinite period of time.

11. Accounting Concept 2 Going Concern Concept Effects – Going Concern Concept A business is judged on the basis of capacity to earn profits in future. In absence of this concept, cost of fixed asset will be treated as expense in year of its’ purchase. On the basis of this concept, depreciation is charged on fixed assets. Enables the business entities to borrow loan from banks or financial institutions.

12. Accounting Concept 3 Money Measurement Concept Case Analysis:- Joe ltd. is planning to set – up a soap factory in next two months. Following is the list of assets available with the company which can be presented in two different ways. Mode I Mode II Land measuring 10 acres Cost of factory land Rs. 10,00,000 Office building having: 20 rooms 50 personal computers 50 chairs and tables Office building worth Rs. 500,000 Cost of personal laptops Rs. 15,00,000 Tables and Chairs worth Rs. 750,000 Raw Material of 2000 Kgs to manufacture soaps Raw Material cost Rs. 25,00,000

13. Accounting Concept 3 Money Measurement Concept In accounting, a record is made only of those transactions which can be expressed in terms of money. Non – monetary transactions are not recorded in accounting. Effects – Money Measurement Concept Employees are the assets of the business, but not recorded in the business books of accounts. Qualitative information of business not recorded in the business books of accounts. Serves as a ‘guiding factor’ , as it guides the accountants ‘what transactions to be recorded’ and ‘what transactions are not to be recorded’ in business books of accounts.

14. Accounting Concept 4 Accounting Period Concept Indefinite working life of business entity is split into short periods These short periods = accounting period Accounting period = Financial Year (1st April – 31st March)

15. Accounting Concept 4 Accounting Period Concept Effects – Accounting Period Concept Helps in calculation of tax on the business income calculated for a particular time period. Helps the banks or financial institutions to assess the performance of business entity before granting loan. Helps in predicting the future prospects of business.

16. Accounting Concept 5 Cost Concept Case Analysis:- A shoe manufacturing company purchased a machine for Rs . 250000 for manufacturing the shoes in the year 2017. An additional amount of Rs . 1000 was spent on transporting the machinery to factory site. The company also spent Rs . 2000 for its’ installation. The current market price of the machinery = Rs . 450000 The machinery is recorded in books of accounts for Rs . 253000 (at historical cost) Market price = Rs . 450000 is ignored

17. Accounting Concept 5 Cost Concept Cost Concept All assets are to be recorded in books of accounts at purchase price (or acquisition price). The market price of the asset = ignored.

18. Accounting Concept 5 Cost Concept Effects – Cost Concept As assets are shown at price at which it is acquired, which can be verified from supporting documents/vouchers. Helps in calculating the depreciation on assets.

19. Accounting Concept 6 Dual Aspect Concept Case Analysis:- A manufacturing company purchased a machinery worth Rs . 100,000 for the production of school bags. The two aspects involved in this transaction are:- Reduction in cash balance Owning of machinery The company sold 100 school bags in the market for Rs . 50000. The two aspects involved in this transaction are:- Increase in cash balance Reduction of goods

20. Accounting Concept 6 Dual Aspect Concept Effect - Dual Aspect Concept:- Resulting formation of Accounting Equation Assets = Liabilities + Capital

21. Accounting Concept 7 Realization Concepts Case Analysis 1:- Ora Jewellers , a jewellery company, received an order to supply gold ornaments worth Rs . 500,000 on 1st March 2018. The company supplied the ornaments worth Rs . 200,000 till 31st March 2018 and remaining ornaments were supplied on April 10th 2018. The revenue of the company for the financial year 2017 – 18 is only Rs . 200,000. Mere getting an order is not considered as revenue until the goods are delivered.

22. Accounting Concept 7 Realization Concepts Case Analysis 2:- Ora Jewellers , a jewellery company, received an order to supply gold ornaments worth Rs . 500,000 on 1st March 2018. The company fulfilled the order and delivered all the ornaments worth Rs . 500,000 on 20th March 2018. The company received the payment of Rs . 500,000 on April 15th, 2018. The revenue of the company in financial year 2017 - 2018 will be Rs . 500,000. “Revenue is earned when goods are delivered to customers.”

23. Accounting Concept 7 Realization Concepts Meaning :- Revenue is realized at the time when goods are delivered to the customers. It is incorrect to record the revenue when: Order is received or when customer pays for the goods

24. Accounting Concept 8 Matching Concept Case Analysis:- A salesman earned a commission @5% on sales shipped and recorded in January. The commission of Rs . 5000 was paid to him in February. The company will record the Commission paid to Salesman in the month of January.

25. Accounting Concept 8 Matching Concept Case analysis II Following is the list of transactions of a stationery store for the financial year 2018: Sale: cash Rs . 2000 and credit Rs . 3000 Rent received Rs . 800 out of which Rs . 300 is received for the next year 2018. Salaries paid Rs . 500 Rent paid Rs . 200, out of which Rs . 100 belongs to previous year 2016 By matching the expenses with revenues of the current year, it will result in Net Profit of Rs . 4900 All the revenues earned during accounting period (whether received/not received) and all the expenses incurred (whether paid/not paid) should be taken into account while finding the profit/loss of that year.

26. Accounting Concept 9 Conservatism Meaning The conservatism principle is the general concept of recognizing expenses and liabilities as soon as possible when there is uncertainty about the outcome, but to only recognize revenues and assets when they are assured of being received.

27. Accounting Concept 9 Conservatism Example For example, if the collections staff believes that a cluster of receivables will have a 2% bad debt percentage because of historical trend lines, but the sales staff is leaning towards a higher 5% figure because of a sudden drop in industry sales, use the 5% figure when creating an allowance for doubtful accounts, unless there is strong evidence to the contrary.

28. Accounting Concept 10 Materiality Meaning Materiality is an accounting principle which states that all items that are reasonably likely to impact investors’ decision-making must be recorded or reported in detail in a business’s financial statements using GAAP standards. Essentially, materiality is related to the significance of information within a company’s financial statements. If a transaction or business decision is significant enough to warrant reporting to investors or other users of the financial statements, that information is “material” to the business and cannot be omitted.

29. Accounting Concept 10 Materiality Example 1 Expensing vs. Depreciating Imagine a company purchases an electric pencil sharpener for $15. Typically, the sharpener should be recorded as an asset and then depreciation expense should be recorded throughout its useful life. However, materiality allows you to expense the entire $15 at once. In this scenario, you’re able to expense the entire transaction at once because the information is immaterial. Recording the transaction in this way is unlikely to impact the decision-making process of investors, therefore the $15 cost of the pencil sharpener is immaterial.

30. Accounting Concept 10 Materiality Example 2 Losses Compared to Net Income If a company were to incur a significant loss due to unforeseen circumstances, whether or not this loss is reported depends on the size of the loss compared to the company’s net income. Imagine that a manufacturing company’s warehouse floods and $20,000 in merchandise is destroyed. If the company’s net income is $50 million a year, then the $20,000 loss is immaterial and can be left off its income statement. On the other hand, if the company’s net income is only $40,000, that would be a 50 percent loss. In this case, the loss is material, so it’s crucial that the company makes the information known to its investors and other financial statement users.

31. Accounting Concept 11 Consistency Meaning – Consistency Concept The consistency principle states that once a business chooses one accounting method, this method should be used consistently going forward. Example 1 If you use the cash basis of accounting this should be applied to your cash flow statement, balance sheet, and income statement. It should also be used as you draw up your accounts payable and receivable reports, both now and in the future. You can’t use the accrual basis for your balance sheet and the cash basis for your cash flow statement. This would be inconsistent and violate the consistency principle.

32. Accounting Concept 11 Consistency Example 2 A second comparison would be between the First-In, First Out (FIFO) method and the Last-in, First-out (LIFO) methods of reporting inventory. With FIFO, the oldest inventory costs are removed from the balance sheet first. More recent costs remain on the balance sheet. By contrast, with LIFO, the more recent costs of products come out of your inventory first, leaving the older costs on the balance sheet. Typically reporting based on LIFO results in lower taxes due to a lower net income, while FIFO shows a higher net income. If a business reports using LIFO one year to reduce its tax bill, it can’t switch to FIFO the next to attract investors. This makes trend analysis impossible due to the inconsistency.

33. Accounting Concept 12 Accrual Concept Meaning Accrual accounting is an accounting method that recognizes revenue in the period in which it’s earned and realizable, but not necessarily when the cash is actually received. Similarly, expenses are recognized in the period in which the related revenue is recognized rather than when the related cash is paid. The accrual method of accounting is based on the matching principle, which states that all revenue and expenses must be reported in the same period and “matched” to determine profits and losses for the period. It’s often compared against cash accounting.

34. Accounting Concept 12 Accrual Concept Example 1 Suppose you paid a gym $1,200 for a year-long membership ($100 per month). Using the accrual accounting method, the gym would set up a deferred revenue account (a liability) for the $1,200 to show that it had received the cash but not yet provided the service. As each month of the year passes, the gym can reduce the deferred revenue account by $100 to show it's provided one month of service. It can simultaneously record revenue of $100 each month to show that the revenue has officially been earned through providing the service.

35. Accounting Concept 12 Accrual Concept Example 2 Let’s say that a clothing retailer rents out a storefront for $2,500 per month, paying each month’s rent on the first day of the following month. This means that the landlord doesn’t receive payment until after services have been provided. Using the accrual accounting method, the landlord would set up an accrued revenue receivable account (an asset) for the $2,500 to show that they have provided services but haven’t yet received payment.

36. Accounting Concept 12 Accrual Concept TYPES OF ACCRUALS Deferred Revenue Accrued Revenue Prepaid Expenses Accrued Expenses

37. Accounting Conventions Accounting Conventions are the common practices which are universally followed in recording and presenting accounting information of business. It helps in comparing accounting data of different business or of same units for different periods.

38. Only those transactions, important facts and items are shown which are useful and material for the business. The firm need not record immaterial and insignificant items. 1. Materiality

39. A large company has a building in the hurricane zone during Hurricane Sandy. The company has net income of $10,000,000. The company building is destroyed and after a lengthy battle with the insurance company, the company reports an extra ordinary loss of $10,000. Is it a material information? Example

40. Assume the same example above except the company is a smaller company with only $50,000 of net income. Now the loss is 20% of net income. Is it a material information? Example

41. ABC LTD has a yearly turnover of $100 million. Which of the following information is material to the users of its financial statements? ABC LTD has been sued by XYZ LTD for $10 million as damages for breach of contract. The decision of the Court is still pending. ABC LTD sold goods worth $1 million to its subsidiary DEF LTD. ABC LTD does not disclose details of its operating lease in respect of an office space rented at $10,000 per annum. Poll

42. 2. Full Disclosure Financial Statements and their notes should present all information that is relevant and material to the user’s understanding of the statements.

43. The Game B/W ANTICIPATION and REALISATION 3. Conservatism

44. Making Provision for Bad and Doubtful Debts. Showing Depreciation on Fixed Assets, but not appreciation. Stock valuation sticks to rule of the lower of cost and net realizable value. Cont’d… Let us assume that a company XYZ Ltd. is embroiled in a patent lawsuit. XYZ Ltd. is suing ABC Ltd for patent infringement and is expecting to win a substantial settlement. Since the settlement is not a surety, XYZ Ltd. does not record the gain in the financial statements. WHY??

45. The accounting practices and methods should remain consistent from one accounting period to another. Whatever accounting practice is followed by the business enterprise, should be followed on a consistent basis from year to year. 4. Consistency

46. Poll Which accounting concept states that financial information should be recorded and presented in a manner that is significant to the users of the financial statements? a) Materiality b) Consistency c) Relevance d) Conservatism

47. Poll Which accounting concept states that financial information should be recorded and presented in a manner that is significant to the users of the financial statements? a) Materiality b) Consistency c) Relevance d) Conservatism

48. Poll The accounting concept that assumes that a business will continue to operate indefinitely and not be liquidated is called: a) Going Concern Concept b) Consistency Concept c) Materiality Concept d) Accrual Concept

49. Poll The accounting concept that assumes that a business will continue to operate indefinitely and not be liquidated is called: a) Going Concern Concept b) Consistency Concept c) Materiality Concept d) Accrual Concept

50. Poll According to the Matching Principle, expenses should be recognized in the same period as: a) When they are paid b) When they are incurred c) When they are approved by management d) When they are collected

51. Poll According to the Matching Principle, expenses should be recognized in the same period as: a) When they are paid b) When they are incurred c) When they are approved by management d) When they are collected

52. Poll Which accounting concept requires that financial statements should be prepared in a way that allows users to compare the financial performance and position of a company over different periods? a) Consistency b) Materiality c) Comparability d) Prudence

53. Poll Which accounting concept requires that financial statements should be prepared in a way that allows users to compare the financial performance and position of a company over different periods? a) Consistency b) Materiality c) Comparability d) Prudence

54. Poll Under the Cash Basis of accounting, when is revenue recognized? a) When it is earned b) When it is received in cash c) When it is invoiced d) When it is promised by a customer

55. Poll Under the Cash Basis of accounting, when is revenue recognized? a) When it is earned b) When it is received in cash c) When it is invoiced d) When it is promised by a customer

56. Poll According to the Conservatism Principle, when faced with two acceptable alternatives for reporting financial results, accountants should choose the one that: a) Results in higher profits b) Results in lower profits c) Is more complex d) Is more favorable to the company's stakeholders

57. Poll According to the Conservatism Principle, when faced with two acceptable alternatives for reporting financial results, accountants should choose the one that: a) Results in higher profits b) Results in lower profits c) Is more complex d) Is more favorable to the company's stakeholders

58. Poll The concept that assumes that a business's financial statements should only include items that can be expressed in monetary terms is called: a) Going Concern Concept b) Monetary Unit Concept c) Accrual Concept d) Matching Concept

59. Poll The concept that assumes that a business's financial statements should only include items that can be expressed in monetary terms is called: a) Going Concern Concept b) Monetary Unit Concept c) Accrual Concept d) Matching Concept

60. Placement Questions Accounting concepts and Conventions Going concern Concept Business Entity concept Accrual basis of accounting Convention of Conservatism

61. Types of accounts and their rules (Personal, Real and Nominal) Drawing Fixed vs Current assets Fictitious assets Bill Receivable and Bill Payable Current Liabilities Contingent liabilities Double enter System

62. If you don’t understand the basic accounting concepts then you’re going to have a tough time with the subject. That’s why this unit is crucial to your success in the rest of the course.