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Other accounting concepts (Materiality concept (The principle that…
Other accounting concepts
Materiality concept
The principle that financial statements should disclose items separately that are significant enough to affect evaluation or discussions
Refers to the relative significance or importance of a particular matter in the context of the financial statements as a whole
A matter is material if its omission or misstatement would reasonably influence the decisions of a user of the accounts
An item in the accounts that is too trivial to affect a user's understanding of the financial statements is referred to as immaterial
When preparing financial statements, it is is important to asses what is material and what is not, so that resources are not wasted in the pursuit of excessive detail
For example, a low value office clock or paper shredder may last for several years but it is highly unlikely to be subject to an annual depreciation charge, because it is not worth the effort of keeping such detailed records
There is no absolute measure of materiality, often a rule of thumb will be applied such as defining material items as those with say a value greater than 5% of the profit disclosed by the accounts but it is really a question of judgement. Both the amount and the context in which it appears must be considered
Money measurement concept
The principal that financial accounting information relates only to those activities that can be expressed in money terms
States that accounts will deal only with those items to which a monetary value can be attached
The value can taken from a source document, such as an invoice
For example, if a company purchases a vehicle or an item of stocker uses electricity, the value can be taken from the relevant invoices
Such values may be easily attributed to assets such as machinery and equipment but other assets such as managerial skills or workforce loyalty may be difficult to quantify, because they cannot be evaluated in monetary terms, they do not appear in the accounts
Business entity concept
The principle that financial accounting information relates only to the activities of the business entity and not to the activities of the owners
Means that accountants regard a business as a separate entity, distinct from its owners or managers
Company law recognises this by viewing the company as a separate legal entity independent of its directors and shareholders
Accountants also regard a sole proprietorship or partnership as separate legal entities but only for accounting purposes
The distinction is important because the accountant is trying to measure the financial performance of the business and therefore needs to exclude the private assets and liabilities of the owner
Historic cost concept
The principle that resources are normally stated in accounts at the amount that was paid to acquire them
Ensures the objectivity of accounts is improved as there is supporting independent evidence, such as an invoice to verify an asset's purchase price or the amount paid for an expense
Objectivity is important as it prevents the accountant or management from influencing the financial performance of the business by deciding on a value independently
The use of valuations is to be avoided where possible, as they may be regarded as subjective so accountants prefer to deal with historic costs
While historic costs are objectively verifiable, they tend to be less useful in periods of inflation
Individual assets such as land or property tend to appreciate in value significantly while other assets such as vehicles tend to depreciate
Therefore it is common to prepare modified historic cost accounts
Periodically, companies include more up-to-date valuations for some of their assets
Stable monetary unit concept
The use of monetary units to report items in financial statements
Permits nominal comparative analysis, although the monetary unit may not maintain a constant value
Requires financial statements to be expressed in monetary units
For example, for international comparative purposes, financial statements are often expressed in terms of US dollars
The use of a monetary unit as a basis in the presentation of financial statements assumes the currency remains constant between accounting periods
Changing price levels (inflation) often signifies a change the monetary unit value between accounting periods
Units of constant purchasing power
Requires all non-monetary items (variable and constant real value non-monetary items) in historic cost or current cost-period end financial statements to be restated in terms of the period-end Consumer Price Index (CPI) during exceptional periods of hyperinflation
During exceptional periods of hyperinflation, all non-monetary items are to be restated in terms of the consumer price index as at the end of the accounting period
This seeks to maintain the capital purchasing power during inflationary and deflationary periods
Objectivity concept
States that the production and analysis of accounting information by accounting professionals is conducted in a non-biased manner
Accounts are prepared without recourse to any person opinion of the entity, thus being free of bias and prejudice
Maintained and supported by the use of national and international accounting standards pus the report of an auditor
Realisation concept
This is the principle that states that profit is only recognised when it has been realised
Only realised profits should be included in financial statements
A notable exception for this principle has been the treatment for land and building
It has become commonly accepted that land and buildings are revalued periodically to reflect their current value , this is often performed to provide a more meaningful balance sheet and to deter acquisition for asset stripping
The revaluation of land and buildings generates an unrealised profit
The unrealised profit is never credited to the profit and loss account because it is unrealised
The unrealised profit is credited to a revaluation account, which forms part of the capital reserves or non-distriubutable reserves
Duality concept
This is the principle that states that for every transaction there is a debit and credit book entry
Duality is the cornerstone of the accounting process
Every transaction has two book entries: a donor account (value losing) and a receiver account (value added)
The donor account is known as the 'credit' entry and the receiver account as the 'debit'
It is traditional to refer to the debit account first when recording accounting transactions
Substance over form
Transactions are accounted for by their commercial reality rather than legal form
Requires that when accounting for transactions, they should be presented with reference to their economic substance and not their legal form
For example, the purchase of a fixed asset on hire purchase, the legal ownership does not pass to the purchaser until the final payment has been made. However the accounting substance would be to recognise the fixed asset in the accounts from the date of the hire purchase agreement
Periodicity concept
The period for which a set of business activities is reported in the financial statements
Requires that an entity reports its activity at set time intervals
Reporting period is usually 12 months but it can be more frequent such as quarterly, bi-annually or monthly, subject to the desire of the entity and the requirements of the users of the financial statements
Using equal reporting periods permits comparability between accounting periods.
Two of the most popular accounting reporting period year ends are 30 June and 31 December
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