Introduction of Accounting Concepts
Accounting is a business language which is used to communicate financial information to the company’s stakeholders such as employees, suppliers and customers. The financial statement is regarding the performance and the position of the business to help them have a better decision making. Hence, financial statement have to be prepare based on accounting concepts. Accounting concepts are the fundamental accounting assumptions that act as a foundation for recording business transactions and preparation of final accounts.
Definition of Accounting Concepts
Historical Cost Concept
Business activities are recorded at costs and prices at the time of transactions. Historical cost is an asset’s original cost and is recorded in the entity’s accounting records. The asset price or cost will never adjust for changes due to inflation in the market or changes in economy. The transactions are stated in their original cost when recorded in an organization’s accounting records. Asset, liability and equity should be recorded at its original acquisition cost because historical cost concept is clarified by the cost principle. The historical cost concept are considered verifiable, comparable, consistent and reliable because the records kept on the basis of it. For example, a company brought a property acquired at cost of RM1 500 000 in 2017. The property would be recorded by this amount in the Statement of Financial and Position in the financial year end of 2017. Even though its market value might have gone up to RM2 000 000 in the next year, 2018, the historical cost concept suggests that it should still be recorded at its original cost, RM1 500 000.
Accruals are records of expenses and revenue in the periods in which they are incurred. Accruals concept records revenues that are earned but not when they are received in cash term, and expenses is recorded when they are incurred but not when they are paid. (Refer Diagram 4 in Appendix) They are a key component of the accrual method of accounting. Accrual concept is the most fundamental principle of accounting that requires to record expenses when they are incurred and not when they are paid, and recording revenues when they are earned and not when they are acquired in cash. Accrual concept recognizes revenues as the goods are delivered to the customer. It also recognised expenses as they happen in generation of revenues. The amount of expense, revenue, and profit or loss in a duration will not necessarily replicate the actual level of economic recreation within a business except accruals. For example, customers that purchases by credit are allowed to pay after 30 days. The payments that paid within the 30 days does not need to be recorded in the books of account because it is recognized as revenue. If the payments are paid after 30 days, then it is a need to be recorded in the book of account because it is recognized as expenses. The accrual concept is being applied in The Profit Determination Equation, in which Profit=Revenue-Expenses.
The consistency principle of accounting states that a company should use the same accounting policies and methods for recording similar events or transactions from one financial period to another. (Accounting For Management.Org, 2018) It implies that a business must avoid from changing its accounting policy unless on reasonable grounds or the new method in some way improves reported financial results. If for any valid reasons the accounting policy is changed, a business must reveal the nature of change, the reasons for the change and its effects on the items of financial statements. Consistency concept is important because of the need for comparability, that is, it enables investors and other users of financial statements to easily and correctly compare the financial statements of a company. ( Irfanullah Jan, 2013)
Explanation of Accounting Concepts
Historical Cost Concept
For example, a company brought a property acquired at cost of RM1 500 000 in 2017. The property would be recorded by this amount in the Statement of Financial and Position in the financial year end of 2017. Even though its market value might gone up to RM2 000 000 in the next year, 2018, the historical cost concept suggests that it should still be recorded at its original cost, RM1 500 000.
For example, customers that purchases by credit are allowed to pay after 30 days. The payments that paid within the 30 days does not need to be recorded in the books of account because it is recognized as revenue. If the payments is paid after 30 days then it is a need to be recorded in the book of account because it is recognized as expenses.
For example, Tan Trading has been using reducing balance depreciation method for its furniture. According to consistency concept it should continue to use reducing balance depreciation method in respect of its furniture in the following periods. If the company wants to change it to another depreciation method, for example the straight line method, it must provide in its financial report, the reasons for the change, the nature of the change and the effects of the change on items such as accumulated depreciation.
2.3 Usefulness and Limitations of Accounting Concepts
(I)Historical Cost Concept
Using historical cost concept is objective and verifiable. Historical cost is record at the time of business transaction, therefore original cost of assets can be verified through original invoice or receipt. The original source documents issued from the third parties are required in order to provide the evidence supporting the transactions. Besides, using historical cost concept is easy and simple to apply and straightforward to produce the financial statements.
Historical cost is not realistic because the cost of assets recorded is at the time of purchase but the value of assets change very frequently. For example, the company purchases the land and building for RM100,000 for 2015. But its expected current market value is about RM250,000. The assets are still recorded in the balance sheet at RM100,000. Historical cost concept in preparing financial statements might not be the best guide to the users of accounting information to make decisions, to identify the investment potential or to know the financial status as it does not show the true value of company’s assets. Next, the value of assets recorded by applying historical cost concept is not accurate
(II) Accrual Concept
Accrual concept shows the true profit or loss of the business. It makes it easier to match the overall revenues with expenses. For example, Anna operates a tuition centre. During the year, she receives RM20000 for the services. Her customers still owe her RM500 in the same year. The operating expenses including utility bills paid so far amount to RM1500 while the accrued wages totaled RM5000. Total revenue is RM20500 (20000+500) while total expenses totaled RM6500 (1500+5000). Profit gained is RM14000. Under accrual concept, expenses are taken into account although the payment has not been made. Next, the company will get to enjoy tax benefits. Accrual concept allows expenses to be deducted for the tax year even there is no payment occurs. Depreciation is recognised as a deduction. This ensures the profits are not overstated and effectively reduces the taxable income of businesses, which results in lower tax. (Peggy Tee, 2017)
Applying accrual concept often requires more judgment, guesswork, and estimation than the cash basis of accounting. In other words, accrual accounting may necessitate estimating the amount or timing of uncertain financial events. It is difficult for people without sufficient training or knowledge in accounting and finance to understand as it requires certain skills to do posting to respectively entries.
(III) Consistency Concept
The usefulness of the consistency concept is it can change in method will distort profits and make comparison difficult constantly. For example, Jenny’s Computers, it is a computer retailer and it has historically used FIFO for valuing its inventory. After few years later, Jenny’s business has become quite profitable thus Jenny switch to the LIFO inventory system to minimize the taxable income. According to the consistency principle, Jenny can change the accounting methods for a justifiable reason for example like minimizing taxes. Then, Jenny’s Computers switched from FIFO to LIFO in year 2. But, in year 3, Jenny’s income become extremely loan, she found that using LIFO is not a good decision. Therefore, she switched off LIFO and back to use FIFO. It shows the violation of the consistency principle, Jenny can make changes in accounting method, but she cannot switch back at fourth year after year. (Dave Sran, 2015)
The limitation of consistency concept is it always ignored when the managers trying to report more profits or revenues to avoid through a strict interpretation of the accounting standards. For example, when there is a company operational activity levels remain the same, but it’s profits increased in a sudden. The calculation of cost is determined in large area by the accounting principles and the requirements of financial reporting. For example, Bobby’s IT Company, has been using declining balance depreciation method for its IT equipment. According to consistency concept, the business should continue using the declining balance depreciation method in the following periods. But, if depreciation is charged according to a particular method it should be followed year after year for the purpose of comparison.
2.4 Application of Accounting Concepts to Selected Company’s Annual Report
In Diagram 1, it shows the 2017 annual report of PRG Holdings Berhad (2017, pg 81), in the preparation of its 2017 Financial Statement, the money measurement concept is applied and it is clearly stated under Notes 1 to Financial Statement, corporate information where all items and equipment are presented in Ringgit Malaysia (RM). All transaction done in the financial statement are all presented in RM and they are rounded in to the nearest thousand. In fact, it shows that all transaction and event in financial statement only can be measured in monetary units.
In Diagram 2, it shows the 2017 annual report of PRG Holidays Berhad ( 2017, pg83 ), the historical cost concept is applied in the preparation of its 2017 Financial Statement and it is stated clearly under Notes 4.4 to Financial Statement, significant accounting policies where all assets such as industries, factories and facilities are recorded and measured at the purchase cost. Expenses and expenditure are consists of the costs and they are actually attributed to get the assets. It shows all assets acquired are recorded at theirpurchase prices.
In Diagram 3, it shows the 2017 annual report of PRG Holidays Berhad ( 2017, pg82 ), the consistency concept is applied in the preparation of its 2017 Financial Statement. It is stated under Notes4.6 to Financial Statement, significant accounting policies where by using consonant accounting policies,the financial statement prepared by the subsidiaries have the same reporting period with the financial report prepared by the Company. If there is necessary, the subsidiaries will change their accounting policies to make sure the Group are adopted the consistency policies. It shows that consistency principle is used by the company, year after year, unless change is necessary
In conclusion, we learned about the accounting concepts and convention on like historical cost, accrual and consistency concept. We also learned companies use the accoun?ng concepts to prepare the financial statement. Financial statement usually used by the owner of the business and also some people who are interested in financial statement such as employees, suppliers and customers. The owner of business can read the financial position in the business so that the owner can reduce the risking their business. In this assignment, we as students who are studying accounting were given an opportunity to enhance our knowledge about accounting concepts. Other than that, we also found that accounting principles are very important for accountants to record the financial statement. Lastly, this assignment really help us a lot because we learned and more understanding accounting concept now.