Prepared by D.

El-Hoss

Accounting Principles and Concepts

The Accounting Principles
They are several assumptions concerned with the recording of transactions in the
books. The most important is that the financial statements known as the final
accounts must be drafted in the same way. This is so that there is a common format
that all accounting users of information can understand. The following will use the
financial statements:

1. A banker - to decide on whether to provide the company with loan.

2. Investor - someone wishing to buy the business.

3. The owner to know his profit.

4. Tax department for tax purposes.

This means that the banker, the prospective buyer; of the business, the owner and the

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other people all see the same income statement (trading and profit and loss account)
and balance sheet.

The following accounting principles are followed to provide consistent usable

financial statments:

1) Relevance: Financial information is considered relevant if it affects the

business decisions.

2) Reliability: Information should be free from significant errors, bias &

independently verified.

3) Comparability: Could be compared with other periods and similar

business.

4) Understandability: The financial report "Income statement (trading

& profit & loss account) & balance sheet" must be capable of being
understood by the users of the report.

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The Accounting Concepts

The accounting concepts are the rules that are applied in recording transactions and
preparing the Trading and Profit and Loss account and the Balance sheet.

1. Business Entity Concept

This rule states that only the transactions of the business should be recorded and
NOT the owner’s private transactions.
Example: the owner buys himself groceries will Not be recorded

2. Money Measurement Concept

Only transactions that can be expressed in monetary terms are to be recorded.
Example: the motivational level and skills of the employees will NOT be recorded

3. Historic Cost Concept

All transactions are recorded at their cost to the business.
Example: a machine bought for a bargain at 50% less than what it is worth, will
still be recorded at the cost paid and not at the higher value it may be worth.

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4. Realisation Concept
Profits are realized (actually earned) when cash or a debtor replaces the goods or
services. A transaction is NOT realized when an order is received or when a
debtor pays his debt.
Example: A sale is considered to be realized when a customer takes ownership of
the good or service regardless of whether money is received straight away.

5. Dual Aspect Concept (duality)

Every transaction will affect two items in the business – this is represented by
both a debit AND a credit entry in the ledger. Example: A transaction is
considered to have a giving and taking effect so the purchase of stock for cash
will reduce the cash amount in the balance sheet and increase the stock of goods.

6. Consistency Concept
Transactions of a similar nature should always be recorded in the same (or
consistent) way. This is to ensure that the Profit and Loss Accounts and Balance
Sheets can be meaningfully compared each year.
Example: keeping the percentage rate of depreciation the same every year

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7. Materiality Concept
This concept implies that you should not waste time recording transactions that
are trivial (involving very small amounts of money).

Example: Depreciation on a cheap waste paper bin

Paper clips left over at the end of the year to be used the following year

BE CAREFUL: what is trivial to a large business could be material to a small

business.

8. Accruals (Matching) Concept

The Trading and Profit and Loss Account should only include the income earned
and expenses incurred for the current financial year.
Example: rent still owing at the end of the year should be included in this year’s
expenses.

9. Prudence Concept
This concept states that profits must not be overstated and the value of Assets
must not be shown to be too high. The accountants’ duty is to ensure that the
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readers of the final accounts get a true and proper picture of the financial state of
the business.
Example: writing off a bad debt even though there is a small chance that the
debtor may still pay.

[Link] Concern Concept

It is assumed that a business will continue to exist for a long period of time.
Example: on the last day of the financial year, the government passes a law which
prevents us from selling our product. We should still continue to draw up the final
accounts.

11. Substance over form

The practical view (the substance) is preferred to the legal view (the form) in
Accounting.
Example: a machine bought on hire purchase remains the possession of the seller
until the last payment is made (legal or form view). From an accounting view, the
machine is used in the business and so will be shown on the Balance Sheet as a
fixed asset of the business (substance).

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Balancing off ‘T’ accounts (Ledger Accounts)

Balancing off ‘T’ accounts using Balance c/d and b/d

All debtors, creditors, assets, liabilities & capital accounts will need to be balanced off with a balance
carried down on the last day of the month (Bal. c/d) and a balance brought down on the first day of next
month (Bal. b/d) before being transferred to the Trial Balance.

Bank Account

$ $
1 May Balance b/d 1300 4 May Purchases 400
2 May P Arthur 700 30 May Wages 1000
10 May R Mark 75
15 May Cash 425 31 May Balance c/d 1100
2500 2500
1 June Balance b/d 1100

Balancing of ‘T’ accounts through entry into the Income Statement

Sales, Purchases, Returns Inwards, Returns Outwards, Carriages Inwards, Carriages Outwards, Revenue
accounts (Rent Received) and expenses are closed by posting them to the Income Statement (Profit and

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Loss Account). When you enter them in the Trial Balance the balance will be on the opposite side of the
Income statement entry.

Sales Account

$ $
4 May H King 700
11 May R Wing 1000
25 May D Bing 5000
31 May Income Statement 7000 31 May R Brad 300
7000 7000

Wages Account

$ $
30 May Bank 1000 31 May Income Statement 1000
1000 1000

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The double-entry system for the Asset of Stock (Inventory)

The purchase of stock

Goods that are bought with the prime intention of selling are known in accounting
terms as Purchases or Inventory. Goods are usually sold above cost price with the
difference being Profit. In the event that goods are sold below the cost price then the
difference would be known as a Loss.

In certain circumstances goods purchased from the supplier are returned because they
are faulty or surplus (not needed anymore). In accounting terms these returns are
classified as Returns Outwards or Purchases/Inventory Returns.

In order to record the purchase of stock and any returns outwards to the supplier, two
accounts are opened:

1- Purchases Account in which purchases of goods are recorded.

2- Returns Outwards Account in which goods being returned out to a supplier are
entered. The alternative name for this is the Purchases Returns Account.

Sales of Stock

In accounting terms the word Sales refers to the sale of those goods which were
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bought with the prime intention of re-selling. As a result for an accountant there is a
clear difference between the sale of stock and the disposal of an asset that might bring
money into the firm. For example, a firm that deals in the sale of glass would consi der
the sale of stock items such as glass pots and trays as sales of stock/inventory.
However, if the firm disposed of a delivery van for a sum of money by selling it to
someone outside the firm, then this would NOT be considered as a sale of stock and
would be recorded as a Disposal.

In certain circumstances goods that have been sold to a customer might be returned
inwards to the firm. The accountant will record these returns from the customer as
Returns Inwards or Sales Returns.

In order to record the sale of stock and the returns inwards by customers two accounts
have to be opened:

1- Sales Account in which sales of goods are entered.

2- Returns Inwards Account in which goods being returned into the firm are
entered. The alternative name for this account is the Sales Returns Account.

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Purchase of st ock on credi t

1 August 20X4. Goods costing $1,650 are bought on credit from D

Hoover. First, the double entry effect must be considered.
1 An increase in an asset. The asset of stock is increased on the debit side
of the Purchases/Inventory account.
2 An increase in a liability. As the stock/inventory has not yet been paid
for then the liability to D. Hoover (Creditor) will be shown on the
credit side.

Dr Purchases/Inventory Account Cr
$ $
August 1 D. Hoover 1,650

Dr D. Hoover Account Cr
$ $
August 1 Purchases 1,650
or Inventory

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Purchase of stock for cash

2 August 20X4. Goods/Inventory costing $220 are bought with the owner paying
cash.
1 The asset of stock/inventory is increased, so that a debit entry will be needed on
the purchases account.
2 The asset of cash is decreased and this will be shown as a credit entry in the
cash account.
Dr Purchases/Inventory Account Cr
$ $
August 1 D. Hoover 1,650
August 2 Cash 220

Dr Cash Account Cr
$ $
Aug 2 Cash 220

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Sales of stock on credit

3 August 20X4. Sold goods on credit for $2,250 to B Wright.

1 An asset account is increased. B. Wright is now a debtor (Asset) to the
business and this is recorded on the debit side of his named debtor
account.
2 The asset of stock is decreased. For this a credit entry to reduce the asset of stock
is made in the Sales account.

Dr B. Wright Account Cr
$ $
August 3 Sales 2,250

Dr Sales Account Cr
$ $
August 3 B. Wright 2,250

R e t u r n s I nw a r d s

5 August 20X4. Goods sold to F High for $290 are now returned by him to the
business. This could be for various reasons such as:

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 we have sent him goods of the wrong size, the wrong colour or the wrong
model;
 the goods may have been damaged when transported;
 the goods are of bad quality;

1 The asset of stock is increased by the goods returned and a debit entry is
made in the Returns Inwards or Sales Returns account.
2 A decrease in an asset. The debt of F High is now reduced and this is recorded on
the credit side of his debtor ‘T’ account.
Dr Returns Inwards Account Cr
$ $
August 5 F. High 290

Dr F High Account Cr
$ $
August 5 Returns 290
Inwards

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R et ur ns O ut w ards

6 August 20X4. Goods previously bought for $960 are returned by the firm to K
Watt.
1 The liability of the firm to K Watt is decreased and this is shown by a debit entry
to K Watts creditor account.
2 The asset of stock is decreased by the goods sent out which is entered as a
credit in the Returns Outwards or Purchases Returns.

Dr K Watt Account Cr
$ $
August 6 Returns 960
Outwards

Dr Returns Outwards Account Cr

$ $
August 5 K Watt 960

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The double-entry system for Assets, Capital, Drawings & Liabilities

The double-entry system

We have seen from the horizontal balance sheet that every business
transaction affects two items. In accounting we use the double-entry system to
record the information.

It may be thought that drawing up a new balance sheet after each transaction would
provide all the information required. However, a balance sheet does not given us
enough detail on who the debtors and creditors actually are and what financial
figures apply to each.
•
The accounts for double-entry

The double-entry system divides each account into two halves in the form of
a'T' Consequently each account is commonly referred to as ‘T’ or Ledger
accounts.
The left side of the 'T' account is called the debit (Dr) side and the right side is known as
the credit (cr) side.

1. The owner starts the business with $10,000 in cash on August 1.

Dr Cash Account Cr

August 1 [Link]
Capital
$
10,000
$

Dr Capital Account Cr
$ $
August 1 Cash 10.000

2. A motor van is bought for $2,750 on 2 August

Dr Motor Van Account Cr

$ $
Aug 2 Cash 2,750

Dr Cash Account Cr
$ $

Aug 1 Capital 10,000 Aug 2 Motor Van 2,750

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3. Fixtures bought on credit from Furniture Fitters on 3 August for $1,150.

Dr Fixtures Account Cr
$ $
August 3 Furniture 1,150
Fitters

Dr Furniture Fitters Account Cr

$ $
August 3 Fixtures 1,150

4. Paid the amount owing to Furniture Fitters ($1,150) in cash on 18 August.

Dr Furniture Fitters Account Cr

$ $
August 17 Cash 1150 August 3 Fixtures 1150

Dr Cash Account Cr
$ $

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Capital 10,000 August 2 Motor Van 2,750
August 17 Furniture 1,150
Fitters

Drawings
When a business-person withdraws anything from the firm for his or her personal use
this has to be recorded using double-entry.

Example

25th August Proprietor (Owner) takes $50 cash out of the business for his own use.

Dr Drawings Account Cr
$ $
Aug 25 Cash 50

Dr Cash Account Cr
$ $

August 1 Capital 10,000 August 2 Motor Van 2,750

August 17 Furniture 1,150
Fitters
August 25 Cash 50

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The double-entry system for expenses and revenues

In order to calculate the new capital it will be necessary for the accountant to calculate
profits or losses. Normally the final account outlining the firm's Net Profit/Loss is
calculated once a year because of the time required to gather all the necessary
information. However, some businesses calculate it every six months.

The accountants will need to gather the information on the firm's expenses and
revenues for the time period in question so that the profit or loss can be calculated. To
serve this purpose a separate account is opened for each type of expense and each
type of revenue. For instance there may be accounts as follows:
 Rent Account - Expense
 Wages Account - Expense
 Salaries Account - Expense
 Telephone Account - Expense
 Rent Receivable Account - Revenue
 Postages Account - Expense
 Stationary Account - Expense
 Insurance Account - Expense
 Motor Expenses Account
 General Expenses Account

Notes

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1- Expenses are defined as the day to day costs of running a business.
2- Revenues are the sources of incoming money that arrive mainly from sales in
most firms.
3- Infrequent or small items of expense are usually put into a 'Sundry Expenses
Account' or a 'General Expenses Account'.
4- All Expenses are debited (Dr) on the left-hand side of 'T' account.
5- All Revenues are credited (Cr) on the righ-hand side of the 'T' account.

Example
June 1 Paid for postage stamps by cash $50
June 2 Paid electricity by cheque $229
June 3 Received rent in cash $138
June 4 Paid insurance by cheque $142
Dr Cash Account Cr
$ $
June 3 Rent June 1 Postages 50
Received 138

Dr Bank Account Cr
$ $
June 2 Electricity 229
June 4 Insurance 142

Dr Electricity Account Cr
$ $
June 2 Bank 229

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Dr Insurance Account Cr
$ $
June 4 Bank 142

Dr Postages Account Cr
$ $
June 1 Cash 50

Dr Rent Receivable Account Cr

$ $
June 3 Cash 138

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Trial balance
A Trial Balance is a list of the Balance B/D of every Ledger account. This is done to
check that:

a) every debit entry in the ledger has an equal credit entry

b) the ledger accounts have been balanced off correctly

How to draw up a Trial Balance

The Trial Balance consists of two columns – one for the DEBIT balances b/d and one for
the CREDIT balances b/d. If a ledger account has a Debit balance b/d, then copy it’s
balance in to the Debit column of the Trial Balance (the same for Credit balances b/d –
copy into the Credit column of the Trial Balance).

Example: Trial Balance as at 31 December 20X9

Debit Credit
$ $
Bank 1 100
Wages 1 000
Cash 8 000
Capital
Drawings [Link]
40 000

Purchases 15 000
Sales 7 000
Vehicles 60 000
Debtors 21 900
Creditors 60 000

107 000 107 000

The debit and credit columns of the trial balance must add up to the SAME TOTAL,
otherwise a mistake needs to be found in the ledger.

Notice:

DAX accounts will always have a DEBIT Balance b/d

LIC accounts will always have a CREDIT Balance b/d

D – Debtors A – Assets X – Expenses

L – Liabilities I – Income C – Capital

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 The Accounting Equation
What is accounting?

People and business

Accounting is related to people and business. Firms and individuals need to plan how
they are going to spend their money and what quantity to save. We may write down a
plan, known as a budget.

Recording accounting data

Recording accounting data is an important part of accounting as it is virtually

impossible for humans to record all the information needed in their heads.
Consequently, systems have to be set up to record cash received and paid out and
goods bought and sold.

Classifying and summarising

When the data is being recorded it has to be sorted out so as to be most useful to the
business. This is known as classifying and summarising data.

Communicating information

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Finally they should be able to tell or communicate their results to the owners of the
business, or to others allowed to receive this information.

From the data, someone skilled in accounting should be able to tell whether or not the
business is performing well financially. They should also be able to ascertain the
strengths and weaknesses of the business.

Users of accounting information

The possible users of accounting information can be:

 Owner(s)  The owners of the business want to be able to see whether or not
the business is profitable. In addition they want to know what the financial
resources of the business are being used for.
 A prospective buyer(s)  When the owner wants to sell the business the
buyer(s) will want to see the final accounts of the firm.
 The bank  If the owner want to borrow money for use in the business, then
the bank will need such information.
 Tax inspectors  They need it to be able to calculate the taxes payable.
 A prospective partner  If the owner wants to share ownership with someone
else, then the would-be partner will want such information.
 Investors  People wondering whether or not to invest their money in the
business.
The accounting equation

The whole of financial accounting is based on the accounting equation. If a firm is to

be set up and start trading, then it needs resources to use within the firm (Assets).
These resources can be either supplied by the owner (Capital) or by firms from
outside the business (Liabilities). Using this concept then the accounting equation
follows as:

Resources in the business = Resources Supplied by the owner + Resources supplied by firms from outside the business


Assets = Capital + Liabilities

Resources: What are they? = Resources: Who supplied what?

(Assets) (Capital + Liabilities)

Assets = The resources in the business

Capital = The amount of resources supplied by the owner
Liabilities = The amount of money owing to people outside the business for the use of
their resources e.g. The bank for the use of its money.

It is a fact that the totals of each side will always equal one another, and that will
always be true no matter how many transactions there may be. The actual assets,
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capital and liabilities may change, but the total of the assets will always equal the total
of capital plus liabilities.
 Capital versus Revenue expenditure

1. Definitions

a) CAPITAL EXPENDITURE is money spent to buy fixed assets.

b) REVENUE EXPENDITURE is money spent on the daily running expenses of the

business.

2. Examples of differences between Capital and Revenue expenditure

CAPITAL EXPENDITURE REVENUE EXPENDITURE

Purchase a building Rent a building
Buy a new vehicle Repair a vehicle
Addition to a new building Redecorating existing building
Installation cost of new equipment Electricity costs of using the equipment

From the example, you should note that:

Any money spent when a fixed asset is FIRST purchased must be treated as Capital
Expenditure eg Cost of a new computer; costs to transport the new computer; costs to
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install the new computer; costs to train employees to use the new computer.

Any expenditure on the fixed asset after it has been used for a while is treated as Revenue
Expenditure eg repairs to the computer; electricity costs.

3. Incorrect treatment of expenditure

a) What is the effect if Capital expenditure is incorrectly recorded as Revenue

expenditure?

Example: the purchase of Equipment is incorrectly recorded as Stationery

Answer: Net Profit be lower than it should be (understated)

The Equipment on the Balance Sheet would be lower than it should be
(understated)

b) What is the effect if Revenue expenditure is incorrectly recorded as Capital

expenditure?

Example: repairs to a vehicle is incorrectly recorded in the Vehicle account

Answer: Net Profit would be higher than it should be (overstated)

Vehicles on the Balance Sheet would be higher than it should be
(overstated)