Chapter 2

Accounting Framework
and Concepts

Overview

Learning Outcomes

ACCOUNTING CONCEPTS

Accountants must prepare the financial statements based on

standard rules of accounting called the accounting principles and
concepts. These concepts serve as guidelines in the preparation of
financial statements.

THE OBJECTIVITY CONCEPT

Objective means that it is quantifiable. Since it can easily be

measured, chances are, it would be more agreeable to different
parties

THE HISTORICAL COST CONCEPT

The historical cost concept stipulates that all

assets must be recorded at the original
cost and not the assets current market
value. Historical cost refers to the price or
the actual cost we paid for in the first place.
Example:
ABC Company bought 500 units of item at RM20 each
last month. However, today, the price has increased
to RM25 per unit. Based on historical cost concept,
the inventory will be shown in the companys
statement of financial position today at RM10,000
(500 x RM20) and not RM12,500 (500 x RM25).

MONEY MEASUREMENT CONCEPT

Money measurement concept states that only activities that can be

measured in terms of money should be recorded in the accounting
books.
Accounting is only concerned with those facts which can be measured
in monetary terms and the money value of the transaction is
agreeable to most people.

Money Measurement Concept

cont.

Accounting therefore can never tell you

everything about a business. For example,
accounting does not show the following:
whether the firm has good or bad
managers,
that there are serious problems with the
work force,
that a rival product is about to take away
many of our best customers,

THE SEPARATE ENTITY CONCEPT

According to the separate entity concept, a business entity is seen as

a separate entity, distinct from the owner(s).
The accounting records are kept for the transactions entered by the
business entity and not the transactions entered by the owner
himself.

The Separate Entity Concept

cont.
Examples:
Insurance premiums for the owners kids
education should be excluded from the
expense of the business
The owners house should not be included
in the asset account of the business
Rental received by the owner for the
renting out of his own apartment should
not be included as the business revenue.

THE REALIZATION CONCEPT

One of the pertinent issues in financial accounting is when to take

credit of revenue.
To be consistent with the prudence concept, in general, profit is
taken or realized only when the customer incurs liability for them.

THE DUAL ASPECT CONCEPT

The dual aspect concept states that there are two aspects of
accounting, one represented by the assets of the business and the
other, represented by the claims against the assets.
The concept stipulates that these two aspects are always equal to
each other.

The Dual Aspect Concept cont.

The dual aspect concept is therefore, the

underlying basis of double entry
bookkeeping system and also known as
the accounting equation.

According to the accounting equation:

ASSETS = CAPITAL + LIABILITIES

THE DUAL ASPECT CONCEPT CONT.

CAPITAL

LIABILITIE
S

ASSET
S

THE TIME INTERVAL CONCEPT

When an accountant prepares the final accounts of a business, they

are prepared at regular intervals.
The period it covers is known as the accounting period (commonly be
a year). Hence, the term is known as financial year.

THE STABLE MONEY CONCEPT

The stable money concept assumes that the value of a dollar is stable
and remained unchanged over time. This means that we will
disregard the effect of inflation (or deflation) when we prepare the
accounts.

UNDERLYING ASSUMPTIONS

Underlying assumptions are the accounting principles and concepts

that business entities are assumed to apply in preparing and
presenting their financial statements. These underlying
assumptions are:
Going concern
Accrual basis

GOING CONCERN

Going concern assumption states that an accountant is entitled to

work out the Final Accounts of a business, on the basis that the
business will continue for the foreseeable future. In other words
that it is a going concern.

THE ACCRUAL BASIS

The accrual basis holds that the revenue we earn and the expenses
we bear are recognized at the time they take place, and not at the
time they are actually paid for (which may be several months
later).

The Accrual Basis cont.

Based on the accrual basis:

Revenues are recognized when they are
earned, not when cash is received.
Expenses are recognized when they are
incurred, not when they are paid.
The difference between total revenues and
total expenses are the net income or net
profit (or net loss) for the period.

FURTHER OVERRIDING CONCEPTS

The term overriding here means that these concepts are so

important that in the event that they are in conflict with the basic
concepts, these overriding concepts shall overrule the basic
concepts. Of course, if they do not contradict the basic concepts
then both are acceptable.

FURTHER OVERRIDING CONCEPTS

CONT.
These concepts are:
Materiality
Prudence
Consistency
Substance Over Form

MATERIALITY

An item is said to be material if it is sufficiently important to affect

our judgment of the true position of the firm. In other words, any
misstatement which affects the decision of a reasonable user of
the statements is deemed to be material.

MATERIALITY CONT.
Example:

A business may well decide that all

items under RM100 should be treated as
expenses in the period which they were
bought even though they may be in use
in the business for the following ten
years. These items have been
considered to be immaterial and hence
there is little benefit in trying to write
them off over a period of ten years.

PRUDENCE

Also known as conservatism. Prudence simply means to be

cautious or to play safe. In other words, you do not take profit
unless you are pretty sure of earning it; but you must write off
loss even if you are not too sure in incurring it.

PRUDENCE CONT.
Examples:
By applying the prudence concept,
provision is made for all known expenses
and losses, even though the amount is just
an estimation and not certain So, if we
estimate that 10% of all outstanding debts
over and above what has already gone bad,
to be doubtful, then a allowance for
dopubtful debts of 10% must be created as
a matter of prudence. It does not mean
that 10% will go bad in the future.
Probably, everything will prove to be good.
But we must play safe i.e. be prudent.

CONSISTENCY

Consistency means a business must choose one chosen method of

accounting treatment and apply it consistently in every
accounting period unless there is a compelling reason to change
the method.

SUBSTANCE OVER FORM

Transactions and other events should be accounted for and presented

in accordance with their substance and financial reality and not
merely with their legal form. This means that where the legal form
of a transaction differs from its real substance, accounting should
show the transaction in accordance with its real substance.

SUBSTANCE OVER FORM CONT.

Example:
If the stock was bought on credit, from a
legal point of view the stock does not
belong to the business until the price
has been paid for. However, from an
economic point of view, the stock can be
used by the business for resale. Based
on the substance over form concept, the
business will show stock as if it is legally
owned by the business

OTHER QUALITATIVE CHARACTERISTICS

To ensure that financial statements presented are useful to users,

the statements should have the following attributes and
characteristics:
Understandability
Relevance
Comparability
Reliability