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CSS Accountancy & Auditing

World Times Academy, Lahore

Introduction to Accounting Principles


There are general rules and concepts that govern the field of accounting. These general rulesreferred to as basic
accounting principles and guidelinesform the groundwork on which more detailed, complicated, and legalistic
accounting rules are based. For example, the Financial Accounting Standards Board (FASB) uses the basic
accounting principles and guidelines as a basis for their own detailed and comprehensive set of accounting rules and
standards.
The phrase "generally accepted accounting principles" (or "GAAP") consists of three important sets of rules: (1) the
basic accounting principles and guidelines, (2) the detailed rules and standards issued by FASB and its predecessor
the Accounting Principles Board (APB), and (3) the generally accepted industry practices.
If a company distributes its financial statements to the public, it is required to follow generally accepted accounting
principles in the preparation of those statements. Further, if a company's stock is publicly traded, federal law requires
the company's financial statements be audited by independent public accountants. Both the company's management
and the independent accountants must certify that the financial statements and the related notes to the financial
statements have been prepared in accordance with GAAP.
GAAP is exceedingly useful because it attempts to standardize and regulate accounting definitions, assumptions, and
methods. Because of generally accepted accounting principles we are able to assume that there is consistency from
year to year in the methods used to prepare a company's financial statements. And although variations may exist, we
can make reasonably confident conclusions when comparing one company to another, or comparing one company's
financial statistics to the statistics for its industry. Over the years the generally accepted accounting principles have
become more complex because financial transactions have become more complex.

Dual Aspect Concept / Duality Principle in Accounting


Definition
Dual Aspect Concept, also known as Duality Principle, is a fundamental convention of accounting that necessitates
the recognition of all aspects of an accounting transaction. Dual aspect concept is the underlying basis for double
entry accounting system.

Explanation
In a single entry system, only one aspect of a transaction is recognized. For instance, if a sale is made to a customer,
only sales revenue will be recorded. However, the other side of the transaction relating to the receipt of cash or the
grant of credit to the customer is not recognized.
Single entry accounting system has been superseded by double entry accounting. You may still find limited use of
single entry accounting system by individuals and small organizations that keep an informal record of receipts and
payments.
Double entry accounting system is based on the duality principle and was devised to account for all aspects of a
transaction. Under the system, aspects of transactions are classified under two main types:
1. Debit
2. Credit
Debit is the portion of transaction that accounts for the increase in assets and expenses, and the decrease in
liabilities, equity and income.

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Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

Credit is the portion of transaction that accounts for the increase in income, liabilities and equity, and the decrease
in assets and expenses.
The classification of debit and credit effects is structured in such a way that for each debit there is a corresponding
credit and vice versa. Hence, every transaction will have 'dual' effects (i.e. debit effects and credit effects).
The application of duality principle therefore ensures that all aspects of a transaction are accounted for in the financial
statements.

Business Entity Concept


Financial accounting is based on the premise that the transactions and balances of a business entity are to be
accounted for separately from its owners. The business entity is therefore considered to be distinct from its owners for
the purpose of accounting.
Therefore, any personal expenses incurred by owners of a business will not appear in the income statement of the
entity. Similarly, if any personal expenses of owners are paid out of assets of the entity, it would be considered to be
drawings for the purpose of accounting much in the same way as cash drawings.
The business entity concept also explains why owners' equity appears on the liability side of a balance sheet (i.e.
credit side). Share capital contributed by a sole trader to his business, for instance, represents a form of liability
(known as equity) of the 'business' that is owed to its owner which is why it is presented on the credit side of the
balance sheet.
Test Your Understanding
ABC Bakers is a partnership concern owned and operated by Mr. X and Mr. Y. How should the following
transactions be reflected in the books of ABC Bakers?
Mr. X paid his house rent from the business bank account
Mr. Y purchased an oven for the bakery using his personal credit card

Single Economic Entity Concept / Consolidation Accounting


Consolidated financial statements of a group of companies are prepared on the basis of single economic entity
concept.

Definition
Single Economic Entity Concept suggests that companies associated with each other through the virtue of common
control operate as a single economic unit and therefore the consolidated financial statements of a group of companies
should reflect the essence of such arrangement.

Explanation
Consolidated financial statements of a group of companies must be prepared as if the entire group constitutes a
single entity in order to avoid the misrepresentation of the scale of group's activities.
It is therefore necessary to eliminate the effects of any inter-company transactions and balances during the
consolidation of group accounts such as the following:

Inter-company sales and purchases

Inter-company payables and receivables

Inter-company payments such as dividends, royalties & head office charges

Inter-company transactions must be eliminated as if the transactions had not occurred in the first place. Examples of
adjustments that may be required to eliminate the effects of inter-company transactions include:

Elimination of unrealized profit or loss on the sale of assets member companies of a group

Elimination of excess or deficit depreciation expense in respect of a fixed asset purchased from a member
company at a price that was higher or lower than the net book value of the asset in the books of the seller.

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Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

Going Concern
Going concern is one the fundamental assumptions in accounting on the basis of which financial statements are
prepared. Financial statements are prepared assuming that a business entity will continue to operate in the
foreseeable future without the need or intention on the part of management to liquidate the entity or to significantly
curtail its operational activities. Therefore, it is assumed that the entity will realize its assets and settle its obligations in
the normal course of the business.
It is the responsibility of the management of a company to determine whether the going concern assumption is
appropriate in the preparation of financial statements. If the going concern assumption is considered by the
management to be invalid, the financial statements of the entity would need to be prepared on break up basis. This
means that assets will be recognized at amount which is expected to be realized from its sale (net of selling costs)
rather than from its continuing use in the ordinary course of the business. Assets are valued for their individual worth
rather than their value as a combined unit. Liabilities shall be recognized at amounts that are likely to be settled.

What are possible indications of going concern problems?

Deteriorating liquidity position of a company not backed by sufficient financing arrangements.

High financial risk arising from increased gearing level rendering the company vulnerable to delays in payment
of interest and loan principle.

Significant trading losses being incurred for several years. Profitability of a company is essential for its survival
in the long term.

Aggressive growth strategy not backed by sufficient finance which ultimately leads to over trading.

Increasing level of short term borrowing and overdraft not supported by increase in business.

Inability of the company to maintain liquidity ratios as defined in the loan covenants.

Serious litigations faced by a company which does not have the financial strength to pay the possible
settlement.

Inability of a company to develop a new range of commercially successful products. Innovation is often said to
be the key to the long-term stability of any company.

Bankruptcy of a major customer of the company.


Test Your Understanding

Which of the following may affect the going concern status of an entity?
High Gearing Ratio (Proportion of Long Term Debt to Equity)
Availability of short term running finance
Successive trading losses

Time Period Assumption


Definition
This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in
relatively short, distinct time intervals such as the five months ended May 31, 2014, or the 5 weeks ended May 1,
2014. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that
period.

Example
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Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

For example, the property tax bill is received on December 15 of each year. On the income statement for the year
ended December 31, 2013, the amount is known; but for the income statement for the three months ended March 31,
2014, the amount was not known and an estimate had to be used.

Explanation
It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement
of stockholders' equity, and statement of cash flows. Labeling one of these financial statements with "December 31" is
not good enoughthe reader needs to know if the statement covers the one week ended December 31, 2014
the month ended December 31, 2014 the three months ended December 31, 2014 or theyear ended December 31,
2014.

Cost Principal
Definition
From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash equivalent) when an
item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the
amounts shown on financial statements are referred to as historical cost amounts.

Explanation
Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as a general rule,
asset amounts are not adjusted to reflect any type of increase in value. Hence, an asset amount does not reflect the
amount of money a company would receive if it were to sell the asset at today's market value. (An exception is certain
investments in stocks and bonds that are actively traded on a stock exchange.) If you want to know the current value
of a company's long-term assets, you will not get this information from a company's financial statementsyou need to
look elsewhere, perhaps to a third-party appraiser.

Full Disclosure Principle


Definition
If certain information is important to an investor or lender using the financial statements, that information should be
disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that
numerous pages of "footnotes" are often attached to financial statements.

Example
As an example, let's say a company is named in a lawsuit that demands a significant amount of money. When the
financial statements are prepared it is not clear whether the company will be able to defend itself or whether it might
lose the lawsuit. As a result of these conditions and because of the full disclosure principle the lawsuit will be
described in the notes to the financial statements.
A company usually lists its significant accounting policies as the first note to its financial statements.

Money Measurement Concept in Accounting


Definition
Money Measurement Concept in accounting, also known as Measurability Concept, means that only transactions and
events that are capable of being measured in monetary terms are recognized in the financial statements.

Explanation

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Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

All transactions and events recorded in the financial statements must be reduced to a unit of monetary currency.
Where it is not possible to assign a reliable monetary value to a transaction or event, it shall not be recorded in the
financial statements.
However, any material transactions and events that are not recorded for failing to meet the measurability criteria might
need be disclosed in the supplementary notes of financial statements to assist the users in gaining a better
understanding of the financial performance and position of the entity.

Recognition Criteria
The recognition criteria defined by IASB and FASB require that the elements of financial statements (i.e. assets,
liabilities, income and expense) must only be recognized in the financial statements if its cost or value can be
measured with sufficient reliability. Therefore, an entity shall not recognize an element of financial statement unless a
reliable value can be assigned to it.
In many cases however the preparers of financial statements are unable to arrive at a precise amount to be
recognized in the financial statements and must resort to the use of reasonable estimates in arriving at an
approximate value. The use of reasonable estimates is a very important component in the preparation of financial
statements and as long as forming estimates do not involve a high degree of subjectivity and uncertainty they do not
undermine the reliability of financial information.
Where a significant element of financial statement is not recognized because of the inability to measure its monetary
value with sufficient reliability, it may be disclosed in the supplementary notes of financial statements to enhance the
users' understandability and completeness of the presented financial information.

Examples of Application

Skills and competence of employees cannot be attributed an objective monetary value and should therefore
not be recognized as assets in the balance sheet. However, those transactions related to employees that can
be measured reliably such as salaries expense and pension obligations are recognized in the financial
statements.

Where it is not possible to measure reliably the amount of settlement of a legal claim against the company, no
liability is recognized in the financial statements. Instead, the nature and circumstances surrounding the
lawsuit are disclosed in the supplementary notes to the financial statements if considered material.

IAS 38 Intangible Assets and ASC 350 Intangibles - Goodwill and Other require that internally generated
goodwill shall not be recognized as an asset in the balance sheet. This is due to the difficulty in identifying and
measuring the cost of internally generated goodwill as distinct from the cost of running the day to day
operations of the business. However, IFRS 3 Business Combinations and ASC 805 Business
Combinations permit purchased goodwill to be recognized as an asset in the financial statements since the
cost of purchased goodwill is usually determinable objectively as the amount of consideration paid in excess
of the value of other identifiable assets of the acquired business.
Test Your Understanding

ABC United is a professional football club. Which of the following transactions and events may be
recognized in the financial statements of ABC United?
The estimated fair value of the Club's football players taking into account the skill level, experience and form
of individual players.
Staff costs comprising of wages, salaries and similar expenses of ABC United employees
Government sponsored technical training and assistance provided to employees of ABC United free of
charge
The cost of acquisition of player rights by ABC United

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Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

Neutrality / Objectivity
Information contained in the financial statements must be free from bias. It should reflect a balanced view of the
affairs of the company without attempting to present them in a favored light. Information may be deliberately biased or
systematically biased.

Deliberate bias
Deliberate bias: Occurs where circumstances and conditions cause management to intentionally misstate the
financial statements.

Examples:

Managers of a company are provided bonus on the basis of reported profit. This might tempt management to
adopt accounting policies that result in higher profits rather than those that better reflect the company's
performance in line with GAAP.

A company is facing serious liquidity problems. Management may decide to window dress the financial
statements in a manner that improves the company's current ratios in order to hide the gravity of the situation.

A company is facing litigation. Although reasonable estimate of the amount of possible settlement could be
made, management decides to disclose its inability to measure the potential liability with sufficient reliability.

Systematic bias
Systematic bias: Occurs where accounting systems have developed an inherent tendency of favoring one outcome
over the other over time.

Examples:
Accounting policies within an organization may be overly prudent because of cultural influence of an over cautious
leadership.
Test Your Understanding
Under which of the following circumstances will neutrality of information be compromised?
Fixed Asset with a useful life of 5 years is depreciated over 3 years because management believes it is more
prudent to charge higher depreciation expense in the earlier years of an asset's life.
Inventory recognized at the lower of cost or net revenue

Prudence / Conservatism
Preparation of financial statements requires the use of professional judgment in the adoption of accountancy policies
and estimates. Prudence requires that accountants should exercise a degree of caution in the adoption of policies and
significant estimates such that the assets and income of the entity are not overstated whereas liability and expenses
are not under stated.
The rationale behind prudence is that a company should not recognize an asset at a value that is higher than the
amount which is expected to be recovered from its sale or use. Conversely, liabilities of an entity should not be
presented below the amount that is likely to be paid in its respect in the future.
There is an inherent risk that assets and income of an entity are more likely to be overstated than understated by the
management whereas liabilities and expenses are more likely to be understated. The risk arises from the fact that
companies often benefit from better reported profitability and lower gearing in the form of cheaper source of finance
and higher share price. There is a risk that leverage offered in the choice of accounting policies and estimates may

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Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

result in bias in the preparation of the financial statements aimed at improving profitability and financial position
through the use of creative accounting techniques. Prudence concept helps to ensure that such bias is countered by
requiring the exercise of caution in arriving at estimates and the adoption of accounting policies.

Example:
Inventory is recorded at the lower of cost or net realizable value (NRV) rather than the expected selling price. This
ensures profit on the sale of inventory is only realized when the actual sale takes place.
However, prudence does not require management to deliberately overstate its liabilities and expenses or understate
its assets and income. The application of prudence should eliminate bias from financial statements but its application
should not reduce the reliability of the information
Test Your Understanding
Which of the following are examples of the application of prudence concept?
Inventory costing $1000 is recorded at the net realizable value of $1200
Expected loss on a construction contract is recognized immediately in the income statement

Materiality
Information is material if its omission or misstatement could influence the economic decisions of users taken
on the basis of the financial statements (IASB Framework).
Materiality therefore relates to the significance of transactions, balances and errors contained in the financial
statements. Materiality defines the threshold or cutoff point after which financial information becomes relevant to the
decision making needs of the users. Information contained in the financial statements must therefore be complete in
all material respects in order for them to present a true and fair view of the affairs of the entity.
Materiality is relative to the size and particular circumstances of individual companies.

Example - Size
A default by a customer who owes only $1000 to a company having net assets of worth $10 million is immaterial to
the financial statements of the company.
However, if the amount of default was, say, $2 million, the information would have been material to the financial
statements omission of which could cause users to make incorrect business decisions.

Example - Nature
If a company is planning to curtail its operations in a geographic segment which has traditionally been a major source
of revenue for the company in the past, then this information should be disclosed in the financial statements as it is by
its nature material to understanding the entity's scope of operations in the future.
Materiality is also linked closely to other accounting concepts and principles:

Relevance: Material information influences the economic decisions of the users and is therefore relevant to
their needs.

Reliability: Omission or misstatement of an important piece of information impairs users' ability to make correct
decisions taken on the basis of financial statements thereby affecting the reliability of information.

Completeness: Information contained in the financial statements must be complete in all material respects in
order to present a true and fair view of the affairs of the company.
Test Your Understanding

ABC LTD has a yearly turnover of $100 million. Which of the following information is material to the users
of its financial statements?

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Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

ABC LTD has been sued by XYZ LTD for $10 million as damages for breach of contract. The decision of the
Court is still pending.
ABC LTD sold goods worth $1 million to its subsidiary DEF LTD.
ABC LTD does not disclose details of its operating lease in respect of an office space rented at $10,000 per
annum.

Accruals Concept
Financial statements are prepared under the Accruals Concept of accounting which requires that income and expense
must be recognized in the accounting periods to which they relate rather than on cash basis. An exception to this
general rule is the cash flow statement whose main purpose is to present the cash flow effects of transaction during
an accounting period.
Under Accruals basis of accounting, income must be recorded in the accounting period in which it is earned.
Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the
subsequent period in which it will be received. Conversely, prepaid income must be not be shown as income in the
accounting period in which it is received but instead it must be presented as such in the subsequent accounting
periods in which the services or obligations in respect of the prepaid income have been performed.
Expenses, on the other hand, must be recorded in the accounting period in which they are incurred. Therefore,
accrued expense must be recognized in the accounting period in which it occurs rather than in the following period in
which it will be paid. Conversely, prepaid expense must be not be shown as expense in the accounting period in
which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in
respect of the prepaid expense have been performed.

Accruals basis of accounting ensures that expenses are "matched" with the revenue earned in an accounting period.
Accruals concept is therefore very similar to the matching principle.
Test Your Understanding
Which of the following are examples of accruals basis of accounting?
Depreciation
Cash Flow Statement
Prepaid Expense
Provision for Warranty Claims

Matching Concept
Definition
Matching Principle requires that expenses incurred by an organization must be charged to the income statement in
the accounting period in which the revenue, to which those expenses relate, is earned.

Explanation
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Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

Prior to the application of the matching principle, expenses were charged to the income statement in the accounting
period in which they were paid irrespective of whether they relate to the revenue earned during that period. This
resulted in non-recognition of expenses incurred but not paid for during an accounting period (i.e. accrued expenses)
and the charge to income statement of expenses paid in respect of future periods (i.e. prepaid expenses). Application
of matching principle results in the deferral of prepaid expenses in order to match them with the revenue earned in
future periods. Similarly, accrued expenses are charged in the income statement in which they are incurred to match
them with the current period's revenue.
A major development from the application of matching principle is the use of depreciation in the accounting for noncurrent assets. Depreciation results in a systematic charge of the cost of a fixed asset to the income statement over
several accounting periods spanning the asset's useful life during which it is expected to generate economic benefits
for the entity. Depreciation ensures that the cost of fixed assets is not charged to the profit & loss at once but is
'matched' against economic benefits (revenue or cost savings) earned from the asset's use over several accounting
periods.
Matching principle therefore results in the presentation of a more balanced and consistent view of the financial
performance of an organization than would result from the use of cash basis of accounting.

Examples
Examples of the use of matching principle in IFRS and GAAP include the following:

Deferred Taxation
IAS 12 Income Taxes and FAS 109 Accounting for Income Taxes require the accounting for taxable and
deductible temporary differences arising in the calculation of income tax in a manner that results in the

matching of tax expense with the accounting profit earned during a period.
Cost of Goods Sold
The cost incurred in the manufacture or procurement of inventory is charged to the income statement of the
accounting period in which the inventory is sold. Therefore, any inventory remaining unsold at the end of an

accounting period is excluded from the computation of cost of goods sold.


Government Grants
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires the recognition
of grants as income over the accounting periods in which the related costs (that were intended to be
compensated by the grant) are incurred by the entity.
Test Your Understanding

ABC PLC is an insurance company operating in the United States. ABC PLC receives insurance premium in
advance from its customers. The profit before tax of ABC PLC for the year ended 31st December 2012 is
$100,000 whereas the estimated taxable profit amounts to $110,000 against which a current tax provision of
$44,000 (@ 40%) has been recognized in the financial statements. The difference of $10,000 between
accounting profit and taxable profit is due to prepaid income which is taxable on cash basis.
How much income tax expense must ABC PLC recognize during the year ended 31st December 2012 in
accordance with the Matching Principle?
$44,000
$40,000
$48,000

Realisation Concept
Definition
9|Page
Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

Realization concept in accounting, also known as revenue recognition principle, refers to the application of accruals
concept towards the recognition of revenue (income). Under this principle, revenue is recognized by the seller when it
is earned irrespective of whether cash from the transaction has been received or not.

Explanation
In case of sale of goods, revenue must be recognized when the seller transfers the risks and rewards associated with
the ownership of the goods to the buyer. This is generally deemed to occur when the goods are actually transferred to
the buyer. Where goods are sold on credit terms, revenue is recognized along with a corresponding receivable which
is subsequently settled upon the receipt of the due amount from the customer.
In case of the rendering of services, revenue is recognized on the basis of stage of completion of the services
specified in the contract. Any receipts from the customer in excess or short of the revenue recognized in accordance
with the stage of completion are accounted for as prepaid income or accrued income as appropriate.

Example
Motors PLC is a car dealer. It receives orders from customers in advance against 20% down payment. Motors PLC
delivers the cars to the respective customers within 30 days upon which it receives the remaining 80% of the list price.
In accordance with the revenue realization principle, Motors PLC must not recognize any revenue until the cars are
delivered to the respective customers as that is the point when the risks and rewards incidental to the ownership of
the cars are transferred to the buyers.

Importance
Application of the realization principle ensures that the reported performance of an entity, as evidenced from the
income statement, reflects the true extent of revenue earned during a period rather than the cash inflows generated
during a period which can otherwise be gauged from the cash flow statement. Recognition of revenue on cash basis
may not present a consistent basis for evaluating the performance of a company over several accounting periods due
to the potential volatility in cash flows.
Test Your Understanding
Contractors PLC entered into a contract in June 2012 for the construction of a bridge for $10 million. The total
costs to complete the project are estimated to be $6 million of which $3 million has been incurred up to 31st
December 2012. Contractors PLC received $2 million mobilization advance at the commencement of the
project. No further payments have been received.
How much revenue should Contractors PLC recognize in the income statement for the year ended 31st
December 2012?
$2 million
$3 million
$5 million

Faithful Representation
Information presented in the financial statements should faithfully represent the transaction and events that occur
during a period.
Faithfull representation requires that transactions and events should be accounted for in a manner that represents
their true economic substance rather than the mere legal form. This concept is also known as Substance Over Form.
Substance over form requires that if substance of transaction differs from its legal form than such transaction should
be accounted for in accordance with its substance and economic reality.
The rationale behind this is that financial information contained in the financial statements should represent the
business essence of transactions and events not merely their legal aspects in order to present a true and fair view.

Example:
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Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

A machine is leased to Company A for the entire duration of its useful life. Although Company A is not the legal owner
of the machine, it may be recognized as an asset in its balance sheet since the Company has control over the
economic benefits that would be derived from the use of the asset. This is an application of the accountancy concept
of substance over legal form, where economic substance of a transaction takes precedence over its legal aspects.
Test Your Understanding
ABC LTD sold 3000 bread loafs to XYZ Bakers in the year 2011 costing $1 each. XYZ Bakers has the option to
return unsold breads to ABC LTD within 7 days of the sale. In the first week of 2012, XYZ Bakers returned 200
of unsold bread loafs to ABC LTD. How much sale should ABC LTD recognize in the income statement for the
year 2011?
$3000
$2800

Substance over Legal Form


Meaning
Substance over form is an accounting concept which means that the economic substance of transactions and events
must be recorded in the financial statements rather than just their legal form in order to present a true and fair view of
the affairs of the entity.
Substance over form concept entails the use of judgment on the part of the preparers of the financial statements in
order for them to derive the business sense from the transactions and events and to present them in a manner that
best reflects their true essence. Whereas legal aspects of transactions and events are of great importance, they may
have to be disregarded at times in order to provide more useful and relevant information to the users of financial
statements.

Example:
There is widespread use of substance over form concept in accounting. Following are examples of the application of
the concept in the International Financial Reporting Standards (IFRS).

IAS 17 Leases requires the preparers of financial statements to consider the substance of lease arrangements
when determining the type of lease for accounting purposes.
For example, an asset may be leased to a lessee without the transfer of legal title at the end of the lease term.
Such a lease may, in substance, be considered as a finance lease if for instance the lease term is
substantially for entire useful life of the asset or the lease agreement entitles the lessee to purchase the asset
at the end of the lease term at a very nominal price and it is very likely that such option will be exercised by

the lessee in the given circumstances.


IAS 18 Revenue requires accountants to consider the economic substance of the sale agreements while
determining whether a sale has occurred or not.
For example, an entity may agree to sell inventory to someone and buy back the same inventory after a
specified time at an inflated price that is planned to compensate the seller for the time value of money. On
paper, the sale and buy back may be deemed as two different transactions which should be dealt with as such
for accounting purposes i.e. recording the sale and (subsequently) purchase. However, the economic reality of
the transactions is that no sale has in fact occurred. The sale and buy back, when considered in the context of
both transactions, is actually a financing arrangement in which the seller has obtained a loan which is to be
repaid with interest (via inflated price). Inventory acts as the security for the loan which will be returned to the
'seller' upon repayment. So instead of recognizing sale, the entity should recognize a liability for loan obtained

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Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

which shall be reversed when the loan is repaid. The excess of loan received and the amount that is to be
paid (i.e. inflated price) is recognized as finance cost in the income statement.

Importance
The principle of Substance over legal form is central to the faithful representation and reliability of information
contained in the financial statements. By placing the responsibility on the preparers of the financial statements to
actively consider the economic reality of transactions and events to be reflected in the financial statements, it will be
more difficult for the preparers to justify the accounting of transactions in a manner that does fairly reflect the
substance of the situation. However, the principle of substance over form has so far not been recognized by IASB or
FASB as a distinct principle in their respective frameworks due to the difficulty of defining it separately from other
accounting principles particularly reliability and faithful representation.

Other Characteristics of Accounting Information


When financial reports are generated by professional accountants, we have certain expectations of the
information they present to us:
1. We expect the accounting information to be reliable, verifiable, and objective.
2. We expect consistency in the accounting information.
3. We expect comparability in the accounting information.

Reliability, Verifiability, and Objectivity


In addition to the basic accounting principles and guidelines listed in Part 1, accounting information should be reliable,
verifiable, and objective. For example, showing land at its original cost of $10,000 (when it was purchased 50 years
ago) is considered to be more reliable, verifiable, and objective than showing it at its current market value of
$250,000. Eight different accountants will wholly agree that the original cost of the land was $10,000they can read
the offer and acceptance for $10,000, see a transfer tax based on $10,000, and review documents that confirm the
cost was $10,000. If you ask the same eight accountants to give you the lands current value, you will likely receive
eight different estimates. Because the current value amount is less reliable, less verifiable, and less objective than the
original cost, the original cost is used.
The accounting profession has been willing to move away from the cost principle if there are reliable, verifiable, and
objective amounts involved. For example, if a company has an investment in stock that is actively traded on a stock
exchange, the company may be required to show the current value of the stock instead of its original cost.

Consistency
Accountants are expected to be consistent when applying accounting principles, procedures, and practices. For
example, if a company has a history of using the FIFO cost flow assumption, readers of the company's most current
financial statements have every reason to expect that the company is continuing to use the FIFO cost flow
assumption. If the company changes this practice and begins using the LIFO cost flow assumption, that change must
be clearly disclosed.

Comparability
Investors, lenders, and other users of financial statements expect that financial statements of one company can be
compared to the financial statements of another company in the same industry. Generally accepted accounting

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Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495

CSS Accountancy & Auditing

World Times Academy, Lahore

principles may provide for comparability between the financial statements of different companies. For example,
the FASB requires that expenses related to research and development (R&D) be expensed when incurred. Prior to its
rule, some companies expensed R&D when incurred while other companies deferred R&D to the balance sheet and
expensed them at a later date.

Relevance:
Information should be relevant to the decision making needs of the user. Information is relevant if it helps users of the
financial statements in predicting future trends of the business (Predictive Value) or confirming or correcting any past
predictions they have made (Confirmatory Value). Same piece of information which assists users in confirming their
past predictions may also be helpful in forming future forecasts.

Understandability
Transactions and events must be accounted for and presented in the financial statements in a manner that is easily
understandable by a user who possesses a reasonable level of knowledge of the business, economic activities and
accounting in general provided that such a user is willing to study the information with reasonable diligence.
Understandability of the information contained in financial statements is essential for its relevance to the users. If the
accounting treatments involved and the associated disclosures and presentational aspects are too complex for a user
to understand despite having adequate knowledge of the entity and accountancy in general, then this would
undermine the reliability of the whole financial statements because users will be forced to base their economic
decisions on undependable information.

Timeliness of Accounting Information


Timeliness principle in accounting refers to the need for accounting information to be presented to the users in time
to fulfill their decision making needs.
Timeliness of accounting information is highly desirable since information that is presented timely is generally more
relevant to users while conversely, delay in provision of information tends to render it less relevant to the decision
making needs of the users. Timeliness principle is therefore closely related to the relevance principle.
Timeliness is important to protect the users of accounting information from basing their decisions on outdated
information. Imagine the problem that could arise if a company was to issue its financial statements to the public after
12 months of the accounting period. The users of the financial statements, such as potential investors, would probably
find it hard to assess whether the present financial circumstances of the company have changed drastically from
those reflected in the financial statements.

Completeness
Reliability of information contained in the financial statements is achieved only if complete financial information is
provided relevant to the business and financial decision making needs of the users. Therefore, information must be
complete in all material respects.
Incomplete information reduces not only the relevance of the financial statements, it also decreases its reliability since
users will be basing their decisions on information which only presents a partial view of the affairs of the entity.

13 | P a g e
Dated: October 29, 2015

By: Prof. Asif Masood Ahmad


0321 9842495