UNIT 2: ACCOUNTING CONCEPTS AND TRIAL BALANCE

UNIT STRUCTURE

2.0 Overview

2.1 Learning Outcomes

2.2 Accounting Concepts

2.2.1 Business Entity

2.2.2 Dual Aspect

2.2.3 Historical Cost

2.2.4 Accruals

2.2.5 Time Interval

2.2.6 Going Concern

2.2.7 Money Measurement

2.3 Trial Balance

2.4 Summary

2.5 Activities
2.0 OVERVIEW
Uniformity and consistency is very important in preparing and maintaining books of accounts
so that useful information can be provided to users to make informed decisions. To ensure
uniformity and consistency, rules or principles have to be followed in recording and
summarising transactions. These rules or principles are known as accounting concepts.
These accounting concepts are enforced by their incorporation in accounting standards issued
by International Accounting Standards Board (IASB).The major accounting concepts are as
follows:

1 Business Entity
2 Dual Aspect
3 Historical Cost
4 Accruals
5 Time Interval
6 Going Concern
7 Money Measurement

2.1 LEARNING OUTCOMES

By the end of this unit, you should be able to do the following:

1. Distinguish between the different accounting concepts and conventions
2. Explain the importance of the concepts in the preparation of the financial statements
3. Explain the significance of the going concern concept in relation to financial
statetments
4. Prepare the trial balance and explain how it helps in the preparation of the financial
statetments..

2.2.1 BUSINESS ENTITY CONCEPT

According to the business entity concept the transactions of a business must be treated as
being separate from the non-business transactions of the owner/(s). This implies that only
transactions of the business are recorded in the books of the business. Personal expenses of
the owner/(s) are not treated as expenses of the business. When owner/(s) invest money in a
business, it is recorded as a capital contribution by owner/(s) also referred to as equity of the
business. When the owner/(s) withdraw money or goods from the business for personal use, it
is not treated as an expense of the business but rather as drawings. Accounting records made
in the books of a business is from the view of a business rather than from the view of the one
or those owning the business.

For example Mr Paulson started a business by contributing Rs200,000. He purchased Fixtures

and Fittings for Rs40,000, Equipment for Rs50,000 and goods for resale for Rs80,000 and
Rs30,000 remained in hand. These are the assets of the business. They belong to the business
and not to Mr Paulson. Now assume that after a few months, Mr Paulson takes out Rs7,000
cash or goods worth Rs7,000 from the business for personal use. The withdrawal of cash or
goods by Mr Paulson is not an expense of the business but rather a private expense of the
owner, treated as drawings which reduce equity.

2.2.2 DUAL ASPECT CONCEPT

According to the dual concept there are two features of accounting. One is characterised by
the assets of a business and the other by the claims against the assets. This concept is
summarised in the form of the accounting equation as follows:

Assets = Equity + Liabilities

The dual concept is the foundation of accounting. The origin of recording transactions of a
business is provided by this concept. It assumes that each business transaction has two
effects, which is the dual effect. If there is one debit, there must be a corresponding credit and
vice-versa. It therefore implies that every transaction has an equal impact on each side of the
accounting equation, be it on the assets side or equity and liabilities side. However some
transactions may have both effects on only one side of the accounting equation. For example
when assets increase and decrease by the same amount.

The following examples illustrate the dual concept.

Goods sold for cash of Rs20,000 has two effects:

The double entry is as follows:

Debit: Cash Account, which increase assets by Rs20,000

Credit: Sales Account, which increases income by Rs20,000

Additional contribution by owner amounting to Rs100,000 cash

The double entry is as follows:

Debit: Cash Account, which increases assets by Rs100,000

Credit: Equity, which increases equity by Rs100,000

Purchase of Motor Vehicles amounting to Rs500,000 on cash

The double entry is as follows:

Debit: Motor Vehicles Account, which increases assets by Rs500,000

Credit: Cash/Bank Account, which decreases assets by Rs500,000

2.2.3 HISTORICAL COSTS CONCEPT

The historical cost concept states that assets must normally be reflected at cost price in the
books of the business and requires that the cost price be the basis for valuation of assets

. The cost price includes the purchase price and any other costs, for example transportation
costs and installation costs, necessarily incurred to bring the asset into use. It implies that
non-current assets such as buildings, machinery and equipment amongst others are recorded
in the books of the business at cost price. For example assume that a machine was purchased
by a business for Rs700,000. The business incurred Rs10,000 to transport the machine to its
factory and spent Rs20,000 on its installation. The cost of the machine that has to be recorded
in the books of the business is Rs730,000 and not only the purchase price of Rs700,000. The
Rs730,000 is known as the historical cost of the machine. Assume now that after a few
months the market price of the machine is Rs500,000. The business will continue to reflect
the machine at the costs price of Rs730,000 less any depreciation. In addition the historical
costs concept implies that if a business acquires an asset without any payment, which is
without any outflow of resources from the business, the latter cannot reflect the acquired
asset in its books.
2.2.4 ACCRUAL CONCEPT

The accrual concept states that business transaction must be recorded as and when they occur
and not when there are movements of cash. Accruals mean due, which is when an amount is
yet to be received or paid at the end of an accounting period of a business. Income is
recognised in the books of the business when it becomes receivable and not when the cash is
received. In the same vein expenses are recognised in the books when they become payable
and not when cash is paid. This enables income and expenses of a business relating to the
accounting period to be considered by matching the income with the expenses.

For example if a business having an accounting period that ends on 31 December, purchased
goods for resale amounting to Rs25,000 on credit from Fret Ltd on the 12 November 2014
and makes payment on 16 February 2015. The purchase of goods must be recorded on the 12
November 2014 and not on the 16 February 2015. The double entries are as follows:

12 November 2014: To record the purchase of goods for resale

Debit: Purchases Account by Rs25,000

Credit: Accounts Payable Fret Ltd by Rs25,000

16 February 2015: To record the cash transaction

Debit: Accounts Payable Fret Ltd by Rs25,000

Credit: Cash/Bank Account by Rs25,000

2.2.5 TIME INTERVAL

The time interval concept requires that an entity will prepare financial statements at regular
intervals. According to this concept the life of a business in divided into accounting periods
which may be of three months, six months or a year. Usually an accounting period of a
business is a calendar year or a financial year.

An example of an accounting period according to the calendar year is as follows:

 A year that begins on the 1st January and ends on 31st December of same year.
An example of an accounting period according to the financial year is as follows:

 A year that begins on 1st April 2015 and ends on 31st March 2016 or
 A year that begins on 1st July 2015 and ends on 30th June 2016.

According to this concept transactions of a business are recorded in the books of the business
for a specific time period. Goods purchased and sold during a period and any income or
expenses are accounted for and against that period only. The importance of the time interval
concept is as follows:

 It enables a business to calculate the profit/loss and also the tax expenses for a
particular period.
 It enables users of accounting information to assess the performance of a business and
to make forecasts.
 It also helps a business to determine the amount of profits it can distribute to its
owners.

2.2.6 GOING CONCERN

As per the going concern concept a business will continue to exist for the foreseeable future,
which is for at least one accounting period (usually one year) after the end of its current
accounting period. However this concept must be ignored if the business is expected to stop
its operations in the near future or if a liquidity problem is likely to make the business stop its
operations. The importance of this concept is as follows:

 It assures investors that the business will not close done in the near future and that
their investments are safe and that they will continue to earn income from their
investments in the business.
 Financial statements of a business are prepared taking into account that the business is
a going concern unless there is reasonable ground to suspect that the business is likely
to close down in the near future.
 It enables users of accounting information to assess the performance of the business
and make forecasts because a firm is assessed on its capacity to generate profits in the
future.
2.2.7 MONEY MEASUREMENT

According to the money measurement concept accounting information is concerned only with
transactions that:

 Can be reliably measured in monetary units, that is in the currency of a country and
 Most people agree with the monetary value of the transaction.

As per this concept only transactions that can be measured in monetary terms that can be
recorded in the books of the business. For example purchase of goods for resale worth
Rs300,000, sale of goods worth Rs400,000, wages and salaries paid amounting to Rs25,000
are recorded in the books of the business. However sincerity, loyalty and honesty of
employees which cannot be expressed in monetary value are not recorded in the books of the
business.

Furthermore transactions must be recorded in monetary units and not in physical units. For
example at the end of the financial year , a business may own a building with 5,000 square
metres on a land measuring 5 acres, 40 computers, 100 tables, 200 chairs and 5,000kg of raw
materials. These units in which they are measured are different. For accounting purposes they
need to be measured in monetary units so as to be recorded in the books of accounts.

2.3 TRIAL BALANCE

Accounting is based on the double entry principles whereby for each debit entry there is a
corresponding credit entry but never in the same account. Similarly for each credit entry
there is a corresponding debit entry but never in the same account. For example sale of
goods for cash:
Debit: Cash Account
Credit: Sales Account

This implies that the total of all items recorded on the debit side in all accounts must
equal the total of all items recorded on the credit side of the accounts. To verity that the
double entry records have done correctly, a trial balance is prepared.
 A trial balance is a list of account balances that arranged according to whether they are
debit balances or credit balances.

An example of a trial balance is as follows:

MrTorro has been operating in the textile sector for the past fifteen years. He has produced
the following trial balance as at 31 December 2013.

DR CR
Rs Rs
Sales revenue 7,336,000

Trade Payables 457,380

General Expenses 664,000

Advertising Expenses 302,400

Trade Receivables 405,440

Property Expenses 770,000

Wages and Salaries 350,000

Return Inwards 196,000

Equity at 1 January 2013 3,640,980

Carriage Outwards 200,400

Discount Received 126,000

Insurance Expenses 417,600

Bad Debts 10,500

Purchases 3,850,000

Interest on Loan 220,500

Inventory at 1 January 2013 1,680,000

Cash 16,100

Provision for Doubtful Debts at 1 January 2013 17,500

Bank 604,800

Drawings 124,400
Long Term Loan 3,150,000

Carriage Inwards 238,000

Land at cost 3,768,000

Machinery at cost 938,000

Equipment at cost 728,000

Buildings at cost 1,736,000

Accumulated Depreciation at 1 January 2013 on Machinery 187,600

Accumulated Depreciation at 1 January 2013 on Equipment 262,080

Accumulated Depreciation at 1 January 2013 on Buildings 434,000

Return Outwards 399,000

Total 16,615,340 16,615,340

You can observe that the trial balance always has the date of the last day of the accounting
period to which it relates. It is a snapshot of the balances on the ledger accounts at that date.
The totals of the debit side must always equal the total of the credit side. A trial balance can
be prepared at any point of time during the accounting period but one is usually prepared at
the end of the accounting period before the preparation of the financial statements to ensure
that transactions have been correctly recorded according to the double entry principles.

If the trial balance’s debit side total equals that of the credit side, it means that the trial
balance balances. It is not always correct to say that transactions have been correctly recorded
if the trial balance balances. This is because there are certain types of errors that are not
detected by the trial balance and which do not prevent the trial balance from balancing.
Examples of errors that can be revealed by a trial balance are as follows:

 Error of omission: A transaction has been completely omitted from the accounting
records, e.g. a cash sale of R2100 was not recorded.
 Error of commission: A transaction has been recorded in the wrong account, e.g.
rates expense of Rs1500 has been debited to the rent account in error.
 Error of principle: A transaction has conceptually been recorded incorrectly, e.g. a
non-current asset purchase of Rs 1,000 has been debited to the repair expense
account rather than an asset account.
  Compensating error: Two different errors have been made which cancel each other
out, e.g. a rent bill of Rs1,200 has been debited to the rent account as Rs1,400 and a
casting error on the sales account has resulted in sales being overstated by Rs200.
 Error of original entry: The correct double entry has been made but with the wrong
amount, e.g. a cash sale of Rs176 has been recorded as Rs167.
 Reversal of entries: The correct amount has been posted to the correct accounts but
on the wrong side, e.g. a cash sale of Rs1,200 has been debited to sales and credited
to bank.

2.3 Summary
 According to the business entity concept the transactions of a business must be treated
as being separate from the non-business transactions of the owner/(s)
 The dual concept is the foundation of accounting; It assumes that each business
transaction has two effects, which is the dual effect. If there is one debit, there must
be a corresponding credit and vice-versa.
 The historical cost concept states that assets must normally be reflected at cost price
in the books of the business and requires that the cost price be the basis for valuation
of assets
 The accrual concept states that business transaction must be recorded as and when
they occur and not when there are movements of cash.
 The time interval concept requires that an entity will prepare financial statements at
regular intervals.
 The money measurement concept states that only transactions that can be measured in
monetary terms will be recorded in the books of the business.
 A trial balance is a list of account balances that arranged according to whether they
are debit balances or credit balances

2.4 Activity

Activity 1
Explain the going concern concept and explain how it may affect the preparation of
the financial statements.

Activity 2
Explain the advantages and disadvantages when the financial statements are
prepared on the historical cost basis

Activity 3
The following balances were extracted from the book of Mr Paul, sole trader, for the year
ended 31 December 2013

Showroom and shop (cost) 376,705

Depreciation at 1 January 2013 30,915

Motor Vehicles (cost) 200,750

Depreciation at 1 January 2013 29,650

Warehouse (cost) 322,435

Depreciation at 1 January 2013 21,730

Stock at 1 January 2013 96,455

Trade debtors 227,580

Provision for doubtful debts 7,560

Cash at bank 80,730

Trade creditors 143,500

10% Bank loan 74,600

Capital 280,000

Net profit at 1 January 2013 54,530

Sales 2,240,450

Purchases 1,201,160

Wages and salaries 50,875

Directors’ salaries 71,870

Rent paid 27,820

Electricity 19,065
 Bad debts 7,365

Administration expenses 88,925

Distribution costs 102,335

Return inwards 8,415

Bank overdraft 38,000

Discounts allowed 3,455

Carriage inwards 11,095

Insurance 23,900

5,841,870

Required : Prepare the Trial Balance as at 31 December 2013.