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III. Historical Cost Concept

The historical cost accounting system is a system of accounting in which all values are
based on the historic costs incurred.

Assets are normally shown at cost price or the amount paid to acquire them.

This means that a piece of land purchased years ago is still recorded at its original cost
even though its value is considerably higher now.

An advantage of using this principle is that it is objective as there is documentary evidence

to prove the amount paid.

IV. Going Concern Concept

According to this concept, it is assumed that the business will continue for a fairly long
time to come. There is neither the intention nor the necessity to liquidate the particular
business venture in the foreseeable future.

All non-current assets should be valued at historical cost.

Financial statements should be prepared on a going concern basis unless management

either plans to liquidate the entity or to stop trading, or has no other choice but to do so.

V. Prudence Concept

Prudence is to exercise a degree of caution in making judgements about estimates

required under conditions of uncertainty such that assets or income are not overstated
and liabilities or expenses are not understated.

This concept must be applied when preparing financial statements whereby losses are
recognised as soon as it is foreseen (even when the exact amount of loss is not known,
an estimate should be made) and profits should only be recognised when realised.

Prudence requires that accountants should:

• Exercise a degree of caution in the adoption of policies,
• Important estimates such that the assets and income of the entity are not overstated
and 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.

Similarly, liabilities of an entity should not be reflected below the amount that is likely to
be paid in its respect in the future.

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Example
A business purchases inventory for $1,100 but because of a sudden slump in the market,
it can be realised for $900 when the inventory is sold.

Prudence concept requires the inventory to be valued at the lower of cost and net
realisable value, which in this case is the net realisable value of $900. Even though the
inventory has not been sold, the loss needs to be recognised as soon as it is foreseen.

If, however, the inventory can be sold at $1,400, then the inventory will be valued at its
cost of $1,100 simply because it has not been sold yet and profits should only be
recognised when realised in the form of cash or another asset with a reasonably certain
cash value.

VI. Accrual / Matching Concept

Income is recognised in the financial accounts as it is earned, not when the cash is
received. Expenditure is recognised as it is incurred, not when it is paid for.

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. This is to ensure accuracy.

Under the matching concept, when revenue is recorded, expenses directly related to this
revenue should also be recorded at the same time.

Thus, if there is a cause-and-effect relationship between revenue and the expenses,

record them in the same accounting period.

Examples include:
- Expenses incurred but not yet paid in current period i.e. accrued expenses under
current liabilities
- Expenses incurred in the following period but paid for in advance i.e. prepaid expenses
under current asset
- Depreciation should be charged as part of the cost of a non-current asset consumed
during the period of use

VII. Consistency concept

Companies should choose the most suitable accounting methods and treatments. These
must be applied consistently in every period.

Presentation and classification of items should be the same each period unless:
(a) There has been a significant change in the nature of the operations
(b) A review of the financial statement suggests a change would be more appropriate

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(c) A new accounting standard requires a change in presentation

If a new method is deemed better and presents a true and fair view of the financial position
of the company, then changes are allowed. Change(s) and the effect on the profits should
then be disclosed in the financial statements.

If a company had adopted the straight-line method for depreciation purposes in one period,
it cannot adopt reducing balance method in another period for the same asset. Constantly
changing the method would lead to misleading profits being calculated. Moreover, a
comparison of the results of one period with the next can be made if the same accounting
method has been used in both periods.

VIII. Realisation Concept

The realisation concept provides that revenues are recognized only when they are earned,
and not when money is received.

Revenue Recognition Criteria

1. A large part of the major earning process has been completed

2. Any further cost for the completion of the earning process is very slight or can be
accurately confirmed, and
3. The buyer has admitted his liability to pay for the goods or services provided and the
final collection is quite certain.

The Framework’s criteria for recognizing income (revenue):

• It is probable that any future economic benefit associated with the item of revenue
will flow to the entity, and
• The amount of revenue can be measured with reliability

IX. Monetary Measurement Concept

This concept assumes that all business transactions must be in terms of money, in the
currency of a country.

Transactions such as customer loyalty, employee honesty and sincerity which cannot be
expressed in monetary terms are not recorded in the books of accounts although they do
affect the profits and losses of the business entity.

Another aspect of this concept is that the records of the transactions are to be kept in the
monetary unit and not in the physical units.

X. Objectivity

The objectivity principle means that financial information is supported by independent and
unbiased evidence. It involves more than one person’s opinion.

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Information is not reliable if it is based only on the perception of the preparer as he/she
can be too optimistic or pessimistic.

An unethical preparer might even try to mislead users by purposely misrepresenting the
truth.

The objectivity principle is intended to make financial statements useful by ensuring that
they report reliable and verifiable information.

XI. Substance over form

Transactions are accounted for and presented in accordance with their substance and
economic reality and not merely their legal form.

Example
A motor vehicle acquired under a hire purchase agreement should be accounted for as
an owned asset. This is the commercial substance of such a situation, even though it is
not the cash legally.

XII. The Time Interval Concept

For accounting purposes, the lifetime of the business is divided into arbitrary period of a
fixed length. The period may be a month, half year or one year. Final accounts are
prepared at each interval including the statement of financial position and the statement
of profit or loss.

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Topic 3 End-of-Period Adjustments

Learning Objectives

Demonstrate how to perform end-of-period adjustments to ensure financial reports

comply with accounting concepts and conventions.

After studying this topic, you will be able to:

1. Perform end-of-period adjustments such as accruals and prepayments

2. Calculate irrecoverable debts and provide allowance for receivables
3. Calculate annual depreciation charges for the year
4. Calculate profit or loss on disposal of non-current asset

Accruals and Prepayments

Expenses
Expenses represent the decreases in economic benefits during the accounting period in
the form of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than those relating to distributions to equity participants.

A business entity needs services of other parties in its operation to generate revenue. The
services are provided by other parties such as workers, carriers, insurance companies,
electricity supply companies, mechanics, landlords, etc.

The costs for such services are in the form of salaries and wages, carriage inwards and
outwards, insurance premiums, lighting and power, repairs and maintenance and rent, etc.

The modes of payment for these services may differ from one to another, some paid as
soon as the services are rendered, some paid in advance and some paid sometime after
the services has been rendered.

The accrual and matching concepts require that the cost for services already utilized
but not yet paid to be included in the expenses of the year so that they can be matched
with the revenue generated by using those services in the year.

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