2.5. Bases of accounting
Cash basis of accounting
This means that the transactions are recorded only when the
related cash is received or paid.
Accrual basis of accounting
Under this basis al transactions are recorded when they occur,
regardless of when any related cash receipts or payments occur.
Cash basis of accounting is not in conformity with GAAP
(General Accepted Accounting Principles). Accrual basis of accounting specifies
that revenue are earned (recognized) in the period when the revenue transaction
occurs, rather than when cash is collected. Also expenditures are incurred
(recognized) in the period when the goods or services are used or consumed
rather than when they are paid for.
2.6. Users of accounting information
Accounting is often described as the language of business
because it is the medium of communication between a business firm and the
various parties interested in its financial activities. These parties
include:
Owners and shareholders
They rely on accounting information in fact that it is their
money invested in the firm. They would like to ensure that they are getting a
good return on their investments. This is assessed by how much profit the firm
is making and whether their investment is increasing in value. For shareholders
in companies this means they will get good dividends and the market value of
their shares will increase and they can make profit if these were sold.
Management
Board of Directors and Managers use accounting information for
making decisions and in planning of the business operations.
Banks and loan companies
They are interested not only in the firm's profitability but
also in its ability to repay its loans. They rely on the financial reports as
the basis of assessing the firm's liquidity or long term solvency.
Employees
They rely on accounting information in claiming bonuses and
salary increases.
Suppliers
They rely on accounting information to be sure that the firm has
sufficient funds to pay its maturing obligations.
Customers
They are interested to know if the firm is able to continue in
its operations on a long term basis and is capable of meeting its customers
demand for goods.
Prospective investors
They are interested in a firm's profitability and potential for
growth. They rely on accounting information in making their investment
decisions.
Government
Various ministries and departments are interested in a firm's
accounting reports as the basis for taxation, enactment of laws for the
industry, provision of social services to the people. It also wants to ensure
that firms comply with laws on wage payments and employee
benefits.3
3 RL Gupta and M. Radhas wamy, advanced accountancy,
1999
2.7. Accounting principles
Certain fundamental concepts provide a frame work for
recording and reporting business activities,. The reason for these rules is
connected with the fact that different groups may make use of accounts and
these groups all need to be convinced that financial statements presented by a
firm are an accurate reflections of that business. Furthermore it allows users
of these financial statements to make comparisons between different firms
relying that all accounts have been drawn following General Accepted Accounting
Principles. Some of these concepts and principles are as follows;
Accounting entity
This concept states that the business firm is separate and
distinct from its owners. Its books of accounts and records should reflect only
those transactions that pertain to the firm and should not include personal
transactions of the owners.
Going concern
The business firm is assumed to continue its operations
indefinitely unless there is evidence that indicate otherwise. In this aspect
the business should continue to value all its resources at the original
costs.
Unit of measure
All financial records, reports and statements are prepared using
money as the unit of measurement. The specific money currency used must be
clearly indicated.
Accrual basis
In determining the net income (revenue-expenses) revenue is
recognized when earned rather than when cash is collected and expenses are
recognized when goods and services are used rather than when are paid for.
Consistency
When there are alternative methods or policies that a business
firm may use, it is important that whichever method or policy is adopted, it
should be used consistently from one accounting period to another as well as
within one accounting period.
If for unavoidable reasons the method has to be changed, this
should be clearly stated so that those users are aware of the reason for the
change.
Prudence
The business firm is encouraged to take approach in treatment
of profits and losses. If the accountant is faced with a choice of figures
which are both acceptable to use in the financial statements he should use a
figure that will produce a smaller profit. This is also known as the
conservatism principle.
Materiality
Only significant items should be considered when preparing
financial statements. These are items whose omission or non disclosure will
result in a distorted view of the financial statements and will mislead the
users of the same. Items may be considered significant in amount or importance
depending on the nature and size of the firm.
Duality
Every transaction has two aspects and both aspects should be
recognized by the business firm. This is the basis of the double entry system
of bookkeeping or accounting.
Accounting period
The life of a business can be broken into periods of time
usually twelve months during which results can be measured The significance of
this concept is that users do not have to wait until cessation of the business
to determine profits or losses.
Matching principle
In determining the profit or loss from operations at all
times, revenues should be matched against expenses incurred in the process of
generating that revenue in the same income statement. This is related to the
accrual principle.
Cost principle
Assets of a business must be recorded at their original cost.
Cost is determined through an arms-length transaction and in most cases this is
the most objective figure to use as long as the going concern assumption
holds.
Realization concept:
According to this concept, revenue is recognized when a sale
is made. Sale was considered to be made at the point when the property in goods
passes to the buyer and he becomes legally liable to pay this.4
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