7.1 Accounting principles
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International Accounting Standards (IAS) accounting standards, which apply globally, enabling users of accounting information to make reliable judgements and decisions about businesses from a range of countries
Accounting Principles (Concepts) are guidelines for the treatment of accounting transactions.
1. Matching Principle
Definition: Expenses should be matched with the revenues they help to generate.
Explanation:
Application: This principle ensures that income and expenses are recorded in the period they occur, not when the cash is received or paid.
Example: If a business sells goods in December but receives payment in January, the revenue and associated expenses are recorded in December.
2. Business Entity Principle
Definition: A business is treated as a separate entity from its owners.
OR
Business Entity only the transactions relating to the business are recorded in the books of account for the business
Explanation:
Application: Personal transactions of the owner are kept separate from the business’s financial transactions.
Example: An owner’s personal expenses, like a family vacation, should not be recorded in the business accounts.
3. Consistency Principle
Definition: Companies should use the same accounting methods and procedures from period to period.
OR
Consistency the concept that after a business has adopted a particular policy for recording financial transactions, the policy should not be changed without a valid reason
Explanation:
Application: This allows for comparability of financial statements over different periods.
Example: If a business uses the straight-line method for depreciation, it should continue using this method in subsequent periods unless a change is justified.
4. Duality Principle
Definition: Every transaction has a dual effect on the accounting equation.
Explanation:
Application: For every debit entry, there is a corresponding credit entry.
Example: Purchasing equipment for cash increases equipment (asset) and decreases cash (asset).
5. Going Concern Principle
Definition: The business is assumed to continue its operations in the foreseeable future.
OR
Going Concern the assumption that the business will continue to trade in the foreseeable future
Explanation:
Application: Financial statements are prepared under the assumption that the business will not liquidate or significantly curtail its operations.
Example: Assets are valued at cost rather than liquidation value.
6. Historic Cost Principle
Definition: Assets are recorded at their original purchase price.
OR
Historic cost this concept states that transactions should be recorded in the books of account using the actual cost at the time the transaction took place
Explanation:
Application: This provides reliability but may not reflect current market value.
Example: A building purchased for $100,000 ten years ago is recorded at $100,000, regardless of its current value.
7. Materiality Principle
Definition: All significant items should be reported in financial statements.
OR
Materiality allows for the correct accounting treatment to be ignored if the amount involved is insignificant relative to the size of the business
Explanation:
Application: Insignificant items that would not affect the user’s decision can be omitted or aggregated.
Example: Small expenses like stationery can be grouped together rather than itemized.
8. Money Measurement Principle
Definition: Only transactions that can be measured in monetary terms are recorded.
OR
Money Measurement items should only be recorded in the books of accounts if they can be measured in monetary terms overstate to state more than the actual sum
Explanation:
Application: Non-monetary items like employee morale are not recorded in financial statements.
Example: A skilled workforce is valuable but not recorded as an asset.
9. Prudence Principle
Definition: Income and assets should not be overstated, and expenses and liabilities should not be understated.
OR
Prudence states that accounts should reflect a cautious view of the business, that losses should be accounted for as they are anticipated, but profits should not be recognised until realised
Explanation:
Application: This principle ensures that financial statements present a conservative view of the company’s financial position.
Example: Potential irrecoverable Debts (bad debts) are estimated and recorded as an expense even before they occur.
10. Realisation Principle
Definition: Revenue is recognized when it is earned, not necessarily when cash is received.
OR
Realisation the concept that revenues should only be recognised when the exchange of goods and services has taken place
Explanation:
Application: Revenue is recorded when the ownership of goods or services is transferred.
Example: A sale made on credit is recorded as revenue when the goods are delivered, not when payment is received.
^^Past Paper Questions^^
Question 1:A trader values his inventory on the same basis at the end of each financial year.
Which accounting principle is the trader observing?
A consistency
B duality
C matching
D realisation
Question 2:Why are non-current assets depreciated?
1 to avoid overstating the value of non-current assets
2 to charge the cost of an asset as an expense over its lifetime
3 to comply with the accounting principle of historic cost
4 to match capital expenditure against the income it has helped earn
A 1, 2 and 4
B 1, 3 and 4
C 1 and 3 only
D 2 and 3
Question 3:Ali started a business and paid a cheque for $1000 into a business bank account. He recorded this in the books of the business by debiting the bank account and crediting the capital account.
Which accounting principles did he apply?
A business entity and duality
B business entity and going concern
C going concern and matching
D matching and duality
Question 4: Sam always records assets and expenses in his ledger at the price he paid for them. Which accounting principle is he applying?
A business entity
B historic cost
C prudence
D realisation
Question 5: A business purchased machinery for $50,000. How would this transaction be recorded according to the historic cost principle, and why might this present a limitation over time?
Answer: According to the historic cost principle, the machinery would be recorded at $50,000, the price paid at the time of purchase. Over time, this might present a limitation as the machinery’s market value could decrease due to wear and tear or increase due to inflation, yet the financial statements will still reflect the original purchase cost.
