Answer / dr. james ngugi kaburu

(a) Accounting Concepts Bases and Policies
I) Concepts/conventions/principles
Accounting Concepts are broad basic assumptions that
underlie the periodic financial accounts of business
enterprises. Examples of concepts include:
i) The going concern concept: implies that the business will
continue in operational existence for the foreseeable
future, and that there is no intention to put the company
into liquidation or to make drastic cutbacks to the scale of
operations.
Financial statements should be prepared under the going
concern basis unless the entity is being (or is going to be)
liquidated or if it has ceased (or is about to cease)
trading. The directors of a company must also disclose any
significant doubts about the company’s future if and when
they arise.
The main significance of the going concern concept is that
the assets of the business should not be valued at their
‘break-up’ value, which is the amount that they would sell
for it they were sold off piecemeal and the business were
thus broken up.

ii) The accruals concept (or matching concept): states that
revenue and costs must be recognized as they are earned or
incurred, not as money is received or paid. They must be
matched with one another so far as their relationship can be
established or justifiably assumed, and dealt with in the
profit and loss account of the period to which they relate.
Assume that a firm makes a profit of £100 by matching the
revenue (£200) earned from the sale of 20 units against the
cost (£100) of acquiring them.
If, however, the firm had only sold eighteen units, it would
have been incorrect to charge profit and loss account with
the cost of twenty units; there is still two units in stock.
If the firm intends to sell them later, it is likely to
make a profit on the sale. Therefore, only the purchase
cost of eighteen units (£90) should be matched with the
sales revenue, leaving a profit of £90.
 
The balance sheet would therefore look like this:
£
Assets
Stock (at cost, i.e. 2 x £5) 10
Debtors (18 x £10) 180
190
Liabilities
Creditors 100
90
Capital (profit for the period) 90

If, however the firm had decided to give up selling units,
then the going concern concept would no longer apply and the
value of the two units in the balance sheet would be a
break-up valuation rather than cost. Similarly, if the two
unsold units were now unlikely to be sold at more than their
cost of £5 each (say, because of damage or a fall in demand)
then they should be recorded on the balance sheet at their
net realizable value (i.e. the likely eventual sales price
less any expenses incurred to make them saleable, e.g.
paint) rather than cost. This shows the application of the
prudence concept. (See below).
In this example, the concepts of going concern and matching
are linked. Because the business is assumed to be a going
concern it is possible to carry forward the cost of the
unsold units as a charge against profits of the next period.

Essentially, the accruals concept states that, in computing
profit, revenue earned must be matched against the
expenditure incurred in earning it.

iii) The Prudence Concept: The prudence concept states that
where alternative procedures, or alternative valuations, are
possible, the one selected should be the one that gives the
most cautious presentation of the business’s financial
position or results.
Therefore, revenue and profits are not anticipated but are
recognized by inclusion in the profit and loss
account only when realized in the form of either cash or of
other assets the ultimate cash realization of which can be
assessed with reasonable certainty: provision is made for
all liabilities (expenses and losses) whether the amount of
these is known with certainty or is best estimate in the
light of the information available.
Assets and profits should not be overstated, but a balance
must be achieved to prevent the material overstatement of
liabilities or losses.

The other aspect of the prudence concept is that where a
loss is foreseen, it should be anticipated and taken into
account immediately. If a business purchases stock for
£1,200 but because of a sudden slump in the market only £900
is likely to be realized when the stock is sold the prudence
concept dictates that the stock should be valued at £900.
It is not enough to wait until the stock is sold, and then
recognize the £300 loss; it must be recognized as soon as it
is foreseen.
A profit can be considered to be a realized profit when it
is in the form of:
• Cash
• Another asset that has a reasonably certain cash value.
This includes amounts owing from debtors, provided that
there is a reasonable certainty that the debtors will
eventually pay up what they owe.

A company begins trading on 1 January 20X2 and sells goods
worth £100,000 during the year to 31 December. At 31
December there are debts outstanding of £15,000. Of these,
the company is now doubtful whether £6,000 will ever be paid.
The company should make a provision for doubtful debts of
£6,000. Sales for 20x5 will be shown in the profit and loss
account at their full value of £100,000, but the provision
for doubtful debts would be a charge of £6,000. Because
there is some uncertainty that the sales will be realized in
the form of cash, the prudence concept dictates that the
£6,000 should not be included in the profit for the year.

iv) The consistency concept: The consistency concept states
that in preparing accounts consistency should be observed in
two respects.

a) Similar items within a single set of accounts should be
given similar accounting treatment.
b) The same treatment should be applied from one period to
another in accounting for similar items. This enables valid
comparisons to be made from one period to the next.

v) The entity concept: The concept is that accountants
regard a business as a separate entity, distinct from its
owners or managers. The concept applies whether the
business is a limited company (and so recognized in law as a
separate entity) or a sole proprietorship or partnership (in
which case the business is not separately recognized by the law.

vi) The money measurement concept: The money measurement
concept states that accounts will only deal with those items
to which a monetary value can be attributed.
For example, in the balance sheet of a business, monetary
values can be attributed to such assets as machinery (e.g.
the original cost of the machinery; or the amount it would
cost to replace the machinery) and stocks of goods (e.g. the
original cost of goods, or, theoretically, the price at
which the goods are likely to be sold).
The monetary measurement concept introduces limitations to
the subject matter of accounts. A business may have
intangible assets such as the flair of a good manager or the
loyalty of its workforce. These may be important enough to
give it a clear superiority over an otherwise identical
business, but because they cannot be evaluated in monetary
terms they do not appear anywhere in the accounts.
 
vii) The separate valuation principle: The separate
valuation principle states that, in determining the amount
to be attributed to an asset or liability in the balance
sheet, each component item of the asset or liability must be
determined separately.
These separate valuations must then be aggregated to arrive
at the balance sheet figure. For example, if a company’s
stock comprises 50 separate items, a valuation must (in
theory) be arrived at for each item separately; the 50
figures must then be aggregated and the total is the stock
figure which should appear in the balance sheet.

viii) The materiality concept: An item is considered
material if it’s omission or misstatement will affect the
decision making process of the users. Materiality depends on
the nature and size of the item. Only items material in
amount or in their nature will affect the true and fair view
given by a set of accounts.
An error that is too trivial to affect anyone’s
understanding of the accounts is referred to as immaterial.
In preparing accounts it is important to assess what is
material and what is not, so that time and money are not
wasted in the pursuit of excessive detail.
Determining whether or not an item is material is a very
subjective exercise. There is no absolute measure of
materiality. It is common to apply a convenient rule of
thumb (for example to define material items as those with a
value greater than 5% of the net profit disclosed by the
accounts). But some items disclosed in accounts are
regarded as particularly sensitive and even a very small
misstatement of such an item would be regarded as a material
error. An example in the accounts of a limited company
might be the amount of remuneration paid to directors of the
company.
The assessment of an item as material or immaterial may
affect its treatment in the accounts. For example, the
profit and loss account of a business will show the expenses
incurred by he business grouped under suitable captions
(heating and lighting expenses, rent and rates expenses
etc); but in the case of very small expenses it may be
appropriate to lump them together under a caption such as
‘sundry expenses’, because a more detailed breakdown would
be inappropriate for such immaterial amounts.
Example:
a) If a balance sheet shows fixed assets of £2 million and
stocks of £30,000 an error of £20,000 in the depreciation
calculations might not be regarded as material, whereas an
error of £20,000 in the stock valuation probably would be.
In other words, the total of which the erroneous item forms
part must be considered.
b) If a business has a bank loan of £50,000 balance and a
£55,000 balance on bank deposit account, it might well be
regarded as a material misstatement if these two amounts
were displayed on the balance sheet as ‘cash at bank
£5,000’. In other words, incorrect presentation may amount
to material misstatement even if there is no monetary error.
ix) The historical cost convention: A basic principle of
accounting (some writers include it in the list of
fundamental accounting concepts) is that resources are
normally stated in accounts at historical cost, i.e. at the
amount that the business paid to acquire them. An important
advantage of this procedure is that the objectivity of
accounts is maximized: there is usually objective,
documentary evidence to prove the amount paid to purchase an
asset or pay an expense. Historical cost means transactions
are recorded at the cost when they occurred.
In general, accountants prefer to deal with costs, rather
than with ‘values’. This is because valuations tend to be
subjective and to vary according to what the valuation is
for. For example, s
uppose that a company acquires a machine to manufacture its
products. The machine has an expected useful life of four
years. At the end of two years the company is preparing a
balance sheet and has decided what monetary amount to
attribute to the asset.
x) Objectivity (neutrality):An accountant must show
objectivity in his work. This means he should try to strip
his answers of any personal opinion or prejudice and should
be as precise and as detailed as the situation warrants.
The result of this should be that any number of accountants
will give the same answer independently of each other.
Objectivity means that accountants must be free from bias.
They must adopt a neutral stance when analysing accounting
data. In practice objectivity is difficult. Two accountants
faced with the same accounting data may come to different
conclusions as to the correct treatment. It was to combat
subjectivity that accounting standards were developed.
xi) The realization concept: Realization: Revenue and
profits are recognized when realized. The concept states
that revenue and profits are not anticipated but are
recognized by inclusion in the income statement only when
realized in the form of either cash or of other assets the
ultimate cash realization of which can be assessed with
reasonable certainty.
xii) Duality: Every transaction has two-fold effect in the
accounts and is the basis of double entry bookkeeping.
xiii) Substance over form: The principle that transactions
and other events are accounted for and presented in
accordance with their substance and economic reality and not
merely their legal form e.g. a non current asset on Hire
purchase although is not legally owned by the enterprise
until it is fully paid for, it is reflected in the accounts
as an asset and depreciation provided for in the normal
accounting way.
Example 3.1
It is generally agreed that sales revenue should only be
‘realized’ and so ‘recognized’ in the trading, profit and
loss account when:
a) The sale transaction is for a specific quantity of goods
at a known price, so that the sales value of the transaction
is known for certain.
b) The sale transaction has been completed, or else it is
certain that it will be completed (e.g. in the case of
long-term contract work, when the job is well under way but
not yet completed by the end of an accounting period).
c) The critical event in the sale transaction has occurred.
The critical event is the event after which:

i) It becomes virtually certain that cash will eventually be
received from the customer.
ii) Cash is actually received.

Usually, revenue is ‘recognized’
(a) When a cash sale is made.
(b) The customer promises to pay on or before a specified
future date, and the debt is legally enforceable.

The prudence concept is applied here in the sense that
revenue should not be anticipated, and included in the
trading, profit and loss account, before it is reasonably
certain to ‘happen’.
Required
Given that prudence is the main consideration, discuss under
what circumstances, if any, revenue might be recognized at
the following stages of a sale.

(a) Goods have been acquired by the business, which it
confidently expects to resell very quickly.
(b) A customer places a firm order for goods.
(c) Goods are delivered to the customer.
(d) The customer is invoiced for goods.
(e) The customer pays for the goods.
(f) The customer’s cheque in payment for the goods has been
cleared by the bank.

Answer
(a) A sale must never be recognized before a customer has
even ordered the goods. There is no certainty about the
value of the sale, nor when it will take place, even if it
is virtually certain that goods will be sold.
(b) A sale must never be recognized when the customer places
an order. Even though the order will be for a specific
quantity of goods at a specific price, it is not yet certain
that the sale transaction will go through. The customer may
cancel an order, the supplier might be unable to deliver the
goods as ordered or it may be decided that the customer is
not a good credit risk.
(c) A sale will be recognized when delivery of the goods is
made only when:

i) The sale is for cash, and so the cash is received at the
same time.
ii) The sale is on credit and the customer accepts delivery
(e.g. by signing a delivery note).

(d) The critical event for a credit sale is usually the
dispatch of an invoice to the customer. There is then a
legally enforceable debt payable on specified terms, for a
completed sale transaction.
(e) The critical event for a cash sale is when delivery
takes place and when cash is received, both take place at
the same time. It would be too cautious or ‘prudent’ to
await cash payment for a credit sale transaction before
recognizing the sale, unless the customer is a high credit
risk and there is a serious doubt about his ability or
intention to pay.
(f) It would again be over-cautious to wait for clearance of
the customer’s cheques before recognizing sales revenue.
Such a precaution would only be justified in cases where
there is a very high risk of the bank refusing to honour the
cheque.
 
II) Bases
Bases are the methods that have been developed for
expressing or applying fundamental accounting concepts to
financial transactions and items. Examples include:
 Depreciation of Non current Assets (e.g. by straight line
or reducing balance method)
 Treatment and amortization of intangible assets (patents
and trade marks)
 Stocks and work in progress (FIFO, LIFO and AVCO)

III) Policies
Accounting policies are the specific accounting bases judged
by business enterprises to be the most appropriate to their
circumstances and adopted by them for the purpose of
preparing their financial accounts.
Qualities of Useful Financial Information
The four principal qualities of useful financial information
are understandability, relevance, reliability and comparability.

Understandability: an essential quality of the information
provided in the financial statements is that it is readily
understandable by users. For these reason users are assumed
to have a reasonable knowledge of business and economic
activities and accounting.
Relevance: information has the quality of being relevant
when it influences the economic decisions of users by
helping them evaluate past, present or future events or
confirming or correcting their past evaluations. The
relevance of information is affected by its nature and
materiality.
Reliability: information is useful when it is free from
material error and bias and can be depended upon by users to
represent faithfully that which it purports to represent or
could reasonably be expected to represent. To be reliable
then the information should:

a) Be represented faithfully,
b) Be accounted for and presented in accordance with their
substance and economic reality and not merely their legal form,
c) Be neutral i.e. free from bias,
d) Include some degree of caution especially where
uncertainties surround some events and transactions (prudence),
e) Be complete i.e. must be within the bounds of materiality
and cost. An omission can cause information to be false.
Comparability: users must be able to compare the financial
statements of an enterprise through time in order to
identify trends in its financial position and performance.
Users must also be able to compare the financial statements
of different accounting policies, changes in the various
policies and the effect of these changes in the accounts.
Compliance with accounting standards also helps achieve this
comparability.

The Accounting Profession in Kenya
The Accountants Act Cap 531 (1977) establishes the Institute
of Certified Public Accountants of Kenya (ICPAK) and two
boards, to be known as the Registration of Kenya Accountants
Board (RAB) and Kenya Accountants and Secretaries National
Examinations Board (IASNEB)

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