L2 – CONCEPTUAL FRAMWORK OF FINANCIAL REPROTING PREPARED BY FRANCIS ZULU

CONCEPTUAL FRAMEWORK OF FINANCIAL RREPOTING

A. Definition and Context of Conceptual Framework

 A conceptual framework is a set of theoretical principles and concepts that underlie the preparation and
presentation of financial statements. A framework a set of ideas or facts that provide support for explaining

something.
 Relevance of conceptual framework. (1) If no conceptual framework existed, then accounting
standards would be produced on a haphazard basis as particular issues and circumstances arose. These
accounting standards might be inconsistent with one another, or perhaps even contradictory; (2) A strong
conceptual framework means that there are principles in place from which all future accounting standards
draw; (3) It also acts as a reference point for the preparers of financial statement if no accounting
standard governs a particular transaction (although this will be extremely rare); (4) Enables accounting
standards and generally accepted accounting practice (GAAP) to be developed in accordance with agreed
principles; (5) Avoids 'firefighting' where accounting standards are developed in a piecemeal way in
response to specific problems or abuses. 'Firefighting' can lead to inconsistencies between different
standards and between accounting standards and legislation; (6) Lack of a conceptual framework may
mean certain critical issues are not addressed; (7) As transactions become more complex and businesses
become more sophisticated it helps preparers and auditors of accounts to deal with transactions which are
not the subject of an accounting standard; (8) Accounting standards based on principles are ought to be
harder to circumvent; (9) A conceptual framework strengthens the credibility of financial reporting and the
accounting profession; (10) It makes it less likely that the standard setting process can be influenced by
'vested interests'.
 The purpose of the Conceptual Framework. The purpose of the Conceptual Framework is to assist: (1)
the International Accounting Standards Board (IASB) in developing new standards and reviewing existing
and helping to ensure that these are based on consistent concepts; (2) preparers of financial statements
when no IFRS Standard applies to a particular transaction, or when an IFRS Standard offers a choice of
accounting policy; (3) all parties when understanding and interpreting IFRS Standards; (4) In harmonizing
accounting standards and procedures; (5) national standard-setting bodies in developing national
standards; (6) preparers of financial statements in applying International Accounting Standards
(IASs)/International Reporting Standards (IFRSs) and in dealing with topics not yet covered by
IASs/IFRSs; (7) auditors in forming an opinion as to whether financial statements conform with
IASs/IFRSs; (8) users of financial statements in interpreting financial statements; (9) provide those
interested in the work of the IASB with information about its approach to the formulation of IFRSs.

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 Note. The Conceptual Framework is not an accounting standard. It does not override the
requirements in a particular International Financial Reporting (IFRS) Standard.
 Background. The Framework for the Presentation and Preparation of Financial Statements was issued in
1989. In 2004 the Board and the US Financial Accounting Standards Board (FASB) started a joint project to
revise their respective frameworks. As a result of this project the Board issued the Conceptual Framework
for Financial Reporting in 2010. Most of the text from the 1989 Framework was simply rolled over but two
chapters were revised. These covered: (1) The objective of financial reporting; (2) The qualitative
characteristics of useful financial information. The Board and the FASB subsequently suspended work on
this joint project. Several criticisms emerged of the 2010 Conceptual Framework. Some of which were: (1)
It did not cover certain areas, such as derecognition, and presentation and disclosure; (2) Guidance in
some areas was unclear, such as with regards to measurement uncertainty; (3) Some aspects were out of
date, such as recognition criteria for assets and liabilities. As a result of criticism, the conceptual framework
was identified as a priority project so, in 2012, the Board restarted this project without the FASB. A
Discussion Paper outlining the Board’s thinking was published in 2013 and an Exposure Draft of the
proposed amendments was published in 2015. Feedback from these documents informed the revised
Conceptual Framework, which was published in 2018.
 The scope of the conceptual framework. The framework deals with: (1) the objective of financial
statements; (2) the qualitative characteristics that determine the usefulness of information in financial
statements; (3) the definitions of the elements from which financial statements are constructed; (4)
recognition and measurement of the elements from which financial statements are constructed; (5) the
concepts and principles governing the preparation of financial statements; (6) Assumptions underpinning
the preparation of financial statements.

B. The objective of financial statements

 The Conceptual Framework states that the purpose of financial reporting is to provide information to
current and potential investors, lenders and other creditors that will enable them to make

decisions about providing economic resources to an entity. If investors, lenders and creditors are
going to make these decisions then they require information that will help them to assess: (1) an entity’s
potential future cash flows, and (2) management’s stewardship of the entity’s economic resources. To
assess an entity’s future cash flows, users need information about: (1) economic resources of the entity
e.g. assets; (2) economic claims against the entity e.g. liabilities and equity; (3) changes in economic
resources and claims e.g. income and expenses.
 The objective of financial statements is to provide information about: (1) the financial position of an
entity (provided mainly in the statement of financial position); (2) the financial performance (provided
mainly in the statement of comprehensive income) and (3) changes in the financial position of an entity

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(provided in the statement of changes in equity and statement of cash flows) that is useful to a wide range
of users in making economic decisions.

C. Qualitative characteristics of useful financial information

1. Fundamental characteristics
 The conceptual framework states that financial information is only useful if it is: (1) relevant and
a faithful representation of an entity’s transactions.
 Relevance and faithful representation are the fundamental characteristics of useful financial
information.
1.1. Relevance. Information is relevant if it has the ability to influence the economic decisions of users and

it is provided in time to influence those decisions. Qualities of relevance - information that is relevant
has predictive, or confirmatory value. Predictive value enables users to evaluate or assess past,
present or future events. Confirmatory value helps users to confirm or correct past evaluations and
assessments. An entity specific aspect of relevance depends on the size of the item or company or
error judged in the particular circumstances of its omission or misstatement. A threshold quality is one
that needs to be studied before considering the other qualities of that information. A cut off point - any
information which does not pass the test is not material and is not considered further. Relevant
information will make an impact on the decisions made by users of the financial statements. Relevance
requires management to consider materiality. An item is material if omitting, misstating or obscuring it
would influence the economic decisions of users. Accounting information is relevant if it is connected
with what the user wants. That is, it must influence them to make a decision. Only relevant
information can be useful. Information is relevant when it helps users evaluate past, present or
future events, or it confirms or corrects previous evaluations. The predictive and confirmatory roles of
information are interrelated. Information on financial position and performance is often used to predict
future position and performance and other things of interest to the user, eg likely dividend, wage rises.
The manner of showing information will enhance the ability to make predictions, eg by highlighting
unusual items. The relevance of information is affected by its nature and materiality. Information may
be judged relevant simply because of its nature (eg remuneration of management). In other cases,
both the nature and materiality of the information are important. Materiality is not a primary qualitative
characteristic itself (like reliability or relevance), because it is merely a threshold or cut-off point. Only
transactions which are materially significant must be recorded and reported otherwise, if insignificant
transactions are not recorded, they may obscure more important matters. Information is material if its
omission or misstatement would influence the economic decisions of users. If financial statements are
to be tailored to the needs of each individual user, then they will take longer to prepare. Sometimes the

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information that is most relevant is not the most reliable or vice versa. In such conflicts, the
information that is most relevant of the information that is reliable should be used. This conflict might
also arise over the timeliness of information, e.g. a delay in providing information can make it out of
date and so affect its relevance but reporting on transactions before uncertainties are resolved may
affect the reliability of the information. Information should not be provided until it is reliable.

1.2. Faithful representation. A faithful representation of a transaction would represent its economic
substance rather than its legal form. A perfectly faithful representation would be complete, neutral
and free from error. If information is to represent faithfully, they must be accounted for and
presented in accordance with their substance and economic reality and not merely their legal form.
Completeness - to be understandable information must contain all the necessary descriptions and
explanations. If all aspects of the business are to be shown, this may make the financial statements
less comprehensible. When financial statements are prepared, they should have all its parts and should
portray a whole or rounded picture of the business activities. Financial information must be complete,
within the restrictions of materiality and cost, to be reliable. Omission may cause information to be
misleading. Neutrality - information must be free from bias. Financial statements are not neutral if by
selection or presentation of information they influence the making of a decision or judgement in order
to achieve a predetermined result or outcome. Information must be free from bias to be reliable.
Neutrality is lost if the financial statements are prepared so as to influence the user to make a
judgement or decision in order to achieve a predetermined outcome. Objectivity. Financial statements
should be free from opinions. They should not be prepared in order to satisfy a particular group. They
should be actual facts otherwise they would be considered biased. The problem of bias is dealt with by
external audit. The information must be presented without bias with respect to the one preparing. The
information must be valid, verifiable and based on unbiased evidence. Free from error - information
must be free from error within the bounds of materiality. A material error or an omission can cause the
financial statements to be false or misleading and thus, unreliable and deficient in terms of their
relevance. The Board note that this is not fully achievable, but that these qualities should be
maximized. When preparing financial reports, preparers should exercise prudence. Prudence means
that assets and income are not overstated, and liabilities and expenses are not understated. However,
this does not mean that assets and income should be purposefully understated, or liabilities and
expenses purposefully overstated. Such intentional misstatements are not neutral. All transactions and
other events for the period of reporting must be faithfully recorded and presented. Information must
represent faithfully the transactions it purports to represent in order to be reliable. There is a risk
that this may not be the case, not due to bias, but due to inherent difficulties in identifying the
transactions or finding an appropriate method of measurement or presentation. Where

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measurement of the financial effects of an item is so uncertain, enterprises should not recognize such

an item, eg internally generated goodwill. Neutrality requires information to be free of deliberate or

systematic bias while prudence is a potentially biased concept towards not overstating gains or assets
or understating losses or liabilities. Neutrality and prudence are reconciled by finding a balance that
ensures that the deliberate and systematic overstatement of assets and gains and understatement of
losses and liabilities do not occur. Information must be recorded and reported with cautiousness.
Uncertainties exist in the preparation of financial information, eg the collectability of doubtful
receivables. These uncertainties are recognized through disclosure and through the application of
prudence. Prudence does not, however, allow the creation of hidden reserves or excessive provisions,
understatement of assets or income or overstatement of liabilities or expenses. Substance over form.
Faithful representation of a transaction is only possible if it is accounted for according to its substance
and economic reality, not with its legal form. Reliability. Accounting information provided should be
depended upon when making decisions. For accounting information to be reliable it must be audited
(examined) by qualified and experienced auditors so that accounts are free from error, biases and
misstatement. Information must also be reliable to be useful, ie free from material error and bias.
The user must be able to depend on it being a faithful representation. Even if information is relevant, if
it is very unreliable it may be misleading to recognize it, eg a disputed claim for damages in a legal
action.

2. Enhancing characteristics

2.1. Comparability. Investors should be able to compare an entity’s financial information year-on-year,
and one entity’s financial information with another. An exercise undertaken to judge to what extent
accounting information is similar or not similar. For reasonable conclusion to be made about the
business it is important that its accounting information is comparable. When comparing, use similar
businesses both in size and nature, or use accounting information from the same business from
previous year. If business is starting for the first time a budget could also be used. Users must be able
to compare an entity's financial statements: (a) through time to identify trends; and (b) with other
entity's statements, to evaluate their relative financial position, performance and changes in financial
position. The consistency of treatment is therefore important across like items over time, within the
entity and across all entities. The disclosure of accounting policies is particularly important here. Users
must distinguish between different accounting policies to be able to make a valid comparison of similar
items in the accounts of different entities. Comparability is not the same as uniformity. Entities should
change accounting policies if they become inappropriate. Corresponding information for preceding

periods should be shown to enable comparison over time. compare the financial statements of an entity

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over time to identify trends in the financial position and performance. Compare the financial statements
of different entities to evaluate their relative financial performance and financial position. Accounting
policies upon which financial statements are based should be the same from year to year. The financial
statements should disclose the significant accounting policies that are in use.
2.2. Timeliness. Having information available to decision makers in time to be capable of influencing their
decisions. Older information is less useful. For information to be meaningful, it should be provided at
the time it is required so that timely decisions could be made. Accounts are usually published soon after
the year end.

2.3. Verifiability. Knowledgeable users should be able to agree that a particular depiction of a transaction

offers a faithful representation. Can be direct or indirect. Direct verification means verifying an amount
or other representation through direct observation. Indirect verification means checking the inputs
using the same methodology.
2.4. Understandability. Information should be presented as clearly and concisely as possible. For anybody
to make a meaningful decision they should have clear knowledge of what they are looking at. Any
difficulties arising from its interpretation must be dealt with by those who understand it. The
information must be clear and easy to understand and this requires proper presentation. Users must be
able to understand financial statements. They are assumed to have some business, economic and
accounting knowledge and to be able to apply themselves to study the information property. Complex
matters should not be left out of financial statements simply due to its difficulty if it is relevant
information. Depends on the way in which information is presented and the capabilities of users. Users
have a reasonable knowledge of business and economic activities and are willing to study the
information provided with reasonable diligence.
3. Constraints on relevant and reliable information. Timeliness. Information may become irrelevant if
there is a delay in reporting it. There is a balance between timeliness and the provision of reliable
information. Information may be reported on a timely basis when not all aspects of the transaction are
known, thus compromising reliability. If every detail of a transaction is known, it may be too late to publish
the information because it has become irrelevant. The overriding consideration is how best to satisfy the
economic decision-making needs of the users. Balance between benefits and cost. This is a pervasive
constraint, not a qualitative characteristic. When information is provided, its benefits must exceed the costs
of obtaining and presenting it. This is a subjective area and there are other difficulties: others than the
intended users may gain a benefit; also, the cost may be paid by someone other than the users. It is
therefore difficult to apply a cost-benefit analysis, but preparers and users should be aware of the
constraint. Balance between qualitative characteristics. A tradeoff between qualitative characteristics
of often necessary, the aim being to achieve an appropriate balance to meet the objective of financial

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statements. It is a matter for professional judgement as to the relative importance of these characteristics
in each case.
D. Duties and responsibilities of directors in preparation of financial statements

 Those charged with governance means the person(s) (directors – executive and non-executive
directors) with responsibility for overseeing the strategic direction of the entity
and obligations related to the accountability of the entity. This includes overseeing the financial
reporting process.

 Board of Directors. The most prominent group of actors in corporate governance are the company’s
directors. They can be either executive or non-executive directors (NEDs).

 Directors Duties: (1) Act within their powers; (2) Promote the success of the company; (3) Exercise
independent judgement; (4) Exercise reasonable skill, care and diligence; (5) Avoid conflicts of
interest; (6) Not accept benefits from third parties; (7) Declare an interest in a proposed transaction
or arrangement.

 Directors' considerations. (1) The consequences of decisions in the long term; (2) The interests of
their employees; (3) The need to develop good relationships with customers and suppliers; (4) The
impact of the company on the local community and the environment; (5) The desirability of
maintaining high standards of business conduct and good reputation; (6) The need to act fairly
between all members of the company

 Directors’ Responsibility for the Financial Statements. The directors are responsible for
preparing the annual financial statements in accordance with applicable law and
regulations. Company law requires the directors to prepare financial statements for each financial
year and such financial statements must give a true and fair view. Hence, the directors are required
to: (1) select suitable accounting policies and then apply them consistently; (2) make judgments and
estimates that are reasonable and prudent; and; (3) state whether they have been prepared in
accordance with IFRSs. Directors are responsible for the internal controls necessary to enable the
preparation of financial statements that are free from material misstatement, whether due
to error or fraud and that they provide a true and fair view of the company . They are also
responsible for the prevention and detection of fraud.

 Financial statements of companies are usually audited. An audit is an independent examination of the
accounts to ensure that they comply with legal requirements and accounting standards. The findings
of the audit are reported to the shareholders. Auditors express an opinion as to whether the financial
statements give a true and fair view. True and fair view in auditing means that the financial

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statements are free from material misstatements and faithfully represent the financial
performance and position of the entity. Financial statements will generally show a fair
presentation when: (1) they conform with accounting standards; (2) they conform with the any
relevant legal requirements; (3) they have applied the qualitative characteristics from the framework.

E. Definitions, Recognition, Derecognition, Measurement and Classification of Elements of

Financial

Statements

Element Definition and Location Recognition Derecognition Measurement Classifications

Asset A present economic If (1) It gives Control is lost Historical costs Non-current assets or
resource controlled by the rights or other and current fixed assets. Assets which
entity as a result of past access to future value are purchased for long-term
events from which future economic benefits use to generate income,
economic benefits are as a result of past facilitate production and are
expected to flow to the transactions or not likely to be converted
entity. Assets can be owned events; (2) it can quickly into cash, such as
by the owner or owed to be measured with tangibles (land, buildings,
sufficient property, plant and
external parties. In other reliability; (3) equipment, machinery,
words, an asset is anything there is sufficient furniture and fittings, long-
owned by an organization evidence of its term investments) and
that has monetary value. existence intangibles (development
Value because the costs, good will) etc.
organization will derive
economic benefit from its Current assets. All the
use. It is recognized in the assets of a company that
statement of financial are expected to be sold or
position or balance sheet. used as a result of standard
business operations over
the next year. They are
called current assets
because they are temporal
in nature. They easily
change in value with time
and can be turned into cash
fairly soon. Current assets
include cash in hand and at
bank, cash equivalents,
receivables (debtors),
inventory (stock),
marketable securities
(treasury bills), pre-
payments (advance
payment)

Liability A present obligation of the If (1) there is an Has no present Historical costs Non-current liabilities or
entity to transfer an obligation (legal obligation and current long-term liabilities.
economic resource or or constructive) to value These are debts by
economic benefits as a transfer economic arrangement with creditors
result of a past event. benefits as a concerned and must be paid
These are amounts owed by result of past over a long period of time,
the business (debts) to its transactions or usually more than one year.
trade payables and to its events; (2) it can Examples include long-term
owner(s). They represent be measured with loans (bank loan, mortgage,
the business’s obligation to sufficient liability; debentures, lease
transfer economic benefits (3) there is obligations, bonds payable
to a third party It is sufficient evidence and deferred revenue.

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Element Definition and Location Recognition Derecognition Measurement Classifications

recognized in the statement of its existence.

of financial position or Current liabilities. These
balance sheet. are debts of the business
that must be paid within a
fairly short period of time.
A fairly short period of time
may be taken as one year.
Examples include payables
(creditors), accrued
expenses, loan repayable
within one year, bank
overdraft and tax payable
Equity The residual amount found If only recognition Equity interest Current value Equity share capital or
by deducting all liabilities of criteria of assets is lost ordinary share capital is
the entity from all of the and liabilities are a major source of finance
entity's assets. Equity is the provided that is for any company which
residual interest in the enough to cover provides the rights to vote
assets of the entity after the equity in the meeting of the holder
deducting all its liabilities. element of the company and shares
The owner's share of the profits and claims on assets
net assets of a business. It to the investors. Different
is recognized in the kinds of equity share capital
statement of financial are authorized, issued,
position or balance sheet. subscribed, paid up, rights
and bonus equity.

Preference share capital

are shares of a company’s
shares with dividends that
are paid out to shareholders
before ordinary shares
dividends are issued
Capital Capital is the owner's If only recognition Control is lost Current value Part of equity. This is other
investment of assets into a criteria of asset is than money assets such as
business. Capital is a provided that is machinery, buildings, etc.
subcategory of owner's enough to cover put into business to carry
equity. the capital on business for profit
But it's not the only element purposes.
subcategory. Owners’ Capital put in by owners is
equity includes capital, also called equity.
profits and reserves
(accumulated profits). It is
recognized in the statement
of financial position or
balance sheet.
Income Earnings that increases An increase in The inflows Current value Incomes are earnings that
economic benefits during future economic cease to exist take the form of sales
the accounting period in the benefits arises revenue (trading),
form of inflows or from an increase investment (rental,
enhancements of assets or in an asset (or a dividends, interest
decreases in liabilities. reduction in a payment) tax and non-tax
Transactions that result in liability) and the revenues, grants,
increases in equity other increase can be donations, contributions,
than those relating to measured reliably. commissions, membership
contributions from equity fees and discount received
participants. Increases in etc.
assets or decreases in
liabilities that result in an
increase to equity. It is
recognized in the statement
of profit or loss or income
statement.
Expenses Costs incurred in the A decrease in It ceases to Historical cost These are costs that

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Element Definition and Location Recognition Derecognition Measurement Classifications

running of the business that future economic exist and current reduces the assets and
decreases assets or benefits arises value profits and increases
increases liabilities that from a decrease in liabilities. they can be
result in decreases to equity an asset or an categorized in to: (1)
(excluding distributions increase in a administration expenses
to equity holders). liability and can consist of such items as
be measured managers’ salaries, legal
Decreases in economic reliably and accountancy, stationary
benefits during the and other supplies,
accounting period in the charges, rates and rentals,
form of outflows or insurance, general, the
depletions of assets or depreciation of accounting
occurrences of liabilities. machinery and secretarial
Transactions that result in salaries. Selling and
decreases in equity other distribution expenses
than those relating to consists of such items as
distributions to equity sales staff’s salaries and
participants. It is commission, carriage
recognized in the statement outwards, depreciation of
of profit or loss or income delivery vans, advertising
statement. and display expenses.
Financial charges are
expense items such as bank
charges, interest payments,
and discounts allowed.
Non-elements
Economic Right that has the potential
Resources to produce economic
benefits
Reporting A reporting entity is one
Entity that prepares financial
statements (either by
choice, or as a result of
legal requirements).
Recognition Elements are recognized if recognition provides users with useful financial information. In other words, recognition
must provide relevant information and a faithful representation of the asset or liability, and resulting income,
expenses, or equity movements.
Derecognition Derecognition is the removal of some or all of an asset or liability from the
statement of financial position. This normally occurs when the entity: (1) loses control of the asset, or (2) has no
present obligation for the liability. Accounting for derecognition should faithfully represent the changes in an
entity’s net assets, as well as any assets or liabilities retained. This is achieved by: (1) derecognizing any
transferred, expired or consumed component; (2) recognizing a gain or loss on the above, and (3) recognizing any
retained component.
Measurement When recognized in the financial statements, elements must be quantified in monetary terms. The Conceptual
Framework outlines two broad measurement bases: (1) Historical cost; (2) Current value (this includes fair value,
value-in-use, and current cost). Selecting a measurement base - the information provided to users by the
measurement base must be useful. In other words, it must be relevant and offer a faithful representation of the
transactions that have occurred. When selecting a measurement basis, the Conceptual Framework states that
relevance is maximized if the following are considered: (1) The characteristics of the asset and/or liability; (2) The
ways in which the asset and/or liability contribute to future cash flows. This applies to the Board when developing or
revising an IFRS Standard. It also applies to preparers of financial statements when applying an IFRS Standard
that permits a choice of measurement bases.
Presentation Effective presentation and disclosure is a balance between allowing entities to flexibly report relevant information
about their financial performance and position, and requiring information that enables comparisons to be drawn year
on-
year and with other entities. The Board believes that: (1) entity specific information is more useful than standardized
descriptions; (2) duplication makes financial information less understandable.

F. Fundamental Accounting Concepts

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 These are basic principles, concepts, conventions, rules, assumptions and procedures which underlie
the measurement, treatment and reporting of financial accounting information. They are established by
accountants voluntarily by general consent.
 Accounting is often called the language of the business because the purpose of accounting is to
communicate or report the results of business operations and its various aspects to various users of
accounting information. Part of this language relates to accounting concepts.
 Accounting concepts are also popularly known as Generally Accepted Accounting Principles
(GAAPs). Generally accepted accounting principles encompass the conventions, rules and procedures
necessary to define accepted accounting practice at a particular time....... generally accepted
accounting principles include not only broad guidelines of general application, but also detailed practices
and procedures.
 The term ‘Concept’ is used to mean necessary assumptions and ideas which are fundamental to
accounting practice. In other words, fundamental accounting concepts are broad general assumptions
which underline the periodic financial statements of business enterprises. The reason why some of
these terms should be called concepts is that they are basic assumptions and have a direct bearing on
the quality of financial accounting information. The term ‘convention’ is used to signify customs or
tradition as a guide to the preparation of accounting statements.
 The International Accounting Standards (IAS) to which most professional accounting bodies across the
world subscribe to, recognizes the following fundamental accounting concepts.
1. Going Concern Concept. Accounting assumes that the business entity will continue to operate for a
long time in the future unless there is good evidence to the contrary. The enterprise is viewed as a
going concern, that is, as continuing in operations, at least in the foreseeable future. In other words,
there is neither the intention nor the necessity to liquidate the particular business venture in the
predictable future. Because of this assumption, the accountant while valuing the assets do not take into
account forced sale value of them. Infact, the assumption that the business is not expected to be
liquidated in the foreseeable future establishes the basis for many of the valuations and allocations in
accounting. For example, the accountant charges depreciation of fixed assets values. It is this
assumption which underlies the decision of investors to commit capital to enterprise. Only on the basis
of this assumption can the accounting process remain stable and achieve the objective of correctly
reporting and recording on the capital invested, the efficiency of management, and the position of the
enterprise as a going concern. However, if the accountant has good reasons to believe that the
business, or some part of it is going to be liquidated or that it will cease to operate (say within six-
month or a year), then the resources could be reported at their current values. If this concept is not

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followed, International Accounting Standard requires the disclosure of the fact in the financial
statements together with reasons.
2. Separate Business Entity Concept. In accounting we make a distinction between business and the
owner. All the books of accounts records day to day financial transactions from the viewpoint of the
business rather than from that of the owner. The proprietor is considered as a creditor to the extent of
the capital brought in business by him. For instance, when a person invests ZMW100,000 into a
business, it will be treated that the business has borrowed that much money from the owner and it will
be shown as a ‘liability’ in the books of accounts of business. Similarly, if the owner of a shop were to
take cash from the cash box for meeting certain personal expenditure, the accounts would show that
cash had been reduced even though it does not make any difference to the owner himself. Thus, in
recording a transaction the important question is how does it affects the business? For example, if the
owner puts cash into the business, he has a claim against the business for capital brought in. In so far
as a limited company is concerned, this distinction can be easily maintained because a company has a
legal entity of its own. Like a natural person it can engage itself in economic activities of buying, selling,
producing, lending, borrowing and consuming of goods and services. However, it is difficult to show this
distinction in the case of sole proprietorship and partnership. Nevertheless, accounting still maintains
separation of business and owner. It may be noted that it is only for accounting purpose that
partnerships and sole proprietorship are treated as separate from the owner (s), though law does not
make such distinction. Infact, the business entity concept is applied to make it possible for the owners
to assess the performance of their business and performance of those whose manage the enterprise.
The managers are responsible for the proper use of funds supplied by owners, banks and others.
3. Dual Aspect Concept. Financial accounting records all the transactions and events involving financial
element. Each of such transactions requires two aspects to be recorded. The recognition of these two
aspects of every transaction is known as a dual aspect analysis. According to this concept every
business transaction has dual effect. For example, if a firm sells goods of ZMW10,000 this transaction
involves two aspects. One aspect is the delivery of goods and the other aspect is immediate receipt of
cash (in the case of cash sales). Infact, the term ‘double entry’ bookkeeping has come into vogue
because for every transaction two entries are made. According to this system the total amount debited
always equals the total amount credited. It follows from ‘dual aspect concept’ that at any point in time
owners’ equity and liabilities for any accounting entity will be equal to assets owned by that entity. This
idea is fundamental to accounting and could be expressed as the following accounting equations:

Assets = Liabilities + Owners Equity ...............(1)

Owners’ Equity = Assets - Liabilities ................(2)

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The above relationship is known as the ‘Accounting Equation’. The term ‘Owners Equity’ denotes the
resources supplied by the owners of the entity while the term ‘liabilities’ denotes the claim of outside
parties such as creditors, debenture-holders, bank against the assets of the business. Assets are the
resources owned by a business. The total of assets will be equal to total of liabilities plus owners
capital because all assets of the business are claimed by either owners or outsiders.
4. Money Measurement Concept. In accounting, only those business transactions which can be
expressed in terms of money are recorded. In other words, a fact or transaction or happening which
cannot be expressed in terms of money is not recorded in the accounting books. As money is accepted
not only as a medium of exchange but also as a store of value, it has a very important advantage since
a number of assets and equities, which are otherwise different, can be measured and expressed in
terms of a common denominator. We must realize that this concept imposes two limitations. Firstly,
there are several facts which though very important to the business, cannot be recorded in the books of
accounts because they cannot be expressed in money terms. For example, general health condition of
the Managing Director of the company, working conditions in which a worker has to work, sales policy
pursued by the enterprise, quality of product introduced by the enterprise, though exert a great
influence on the productivity and profitability of the enterprise, are not recorded in the books. Similarly,
the fact that a strike is about to begin because employees are dissatisfied with the poor working
conditions in the factory will not be recorded even though this event is of great concern to the business.
You will agree that all these have a bearing on the future profitability of the company. Secondly, use of
money implies that we assume stable or constant value of kwacha. Taking this assumption means that
the changes in the money value in future dates are conveniently ignored.
5. Accrual Concept. It is generally accepted in accounting that the basis of reporting income and costs is
accrual. Revenue is recognized when it is realized as soon as a right to receive it arises and not
necessarily when money is received. Expenses are recognized when incurred that is when an obligation
to pay the expense arises and not necessarily when money is paid. Income and expenditure treated on
the accrual basis is then recorded and reported in the financial statements of the periods to which they
relate, without regard to the time of cash receipt or cash payment. When cash is received before the
right to receive the money arises, it is accounted as a prepaid income. Thus, it appears as a current
liability in the balance sheet. On the other hand, when cash is paid before an obligation to pay arises, it
is accounted for a prepaid expense and thus recorded as a current asset in the balance sheet. Financial
statements prepared under the accruals basis show users past transactions involving cash and
obligations to pay cash in the future and resources which represent cash to be received in the future.
Accrual concept makes a distinction between the receipt of cash and the right to receive it, and the
payment of cash and the legal obligation to pay it. This concept provides a guideline to the accountant
as to how he should treat the cash receipts and the right related thereto.

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6. The Matching concept. This concept is based on the accounting period concept. In reality we match
revenues and expenses during the accounting periods. Matching is the entire process of periodic
earnings measurement, often described as a process of matching expenses with revenues. In other
words, income made by the enterprise during a period can be measured only when the revenue earned
during a period is compared with the expenditure incurred for earning that revenue. Broadly speaking
revenue is the total amount realized from the sale of goods or provision of services together with
earnings from interest, dividend, and other items of income. Expenses are cost incurred in connection
with the earnings of revenues. Costs incurred do not become expenses until the goods or services in
question are exchanged. Cost is not synonymous with expense since expense is sacrifice made,
resource consumed in relation to revenues earned during an accounting period. Only costs that have
expired during an accounting period are considered as expenses. For example, if a commission is paid
in January 2021, for services enjoyed in November 2020, that commission should be taken as the cost
for services rendered in November 2020. Because of this concept, adjustments are made for all prepaid
expenses, outstanding expenses, accrued income, etc, while preparing periodic reports.
7. Accounting Period Concept. Financial accounting statements are prepared all through the business
lifetime that is broken down in to equal shorter periods known as a accounting periods. Mostly, they are
prepared on annual basis, unless to the contrary when needed earlier before the year end. This is good
for comparison purposes. A year is the most common interval on account of prevailing practice,
tradition, and government requirements. Some firms adopt financial year of the government, some
other calendar year. Although a twelve-month period is adopted for external reporting, a shorter span
of interval, say one month or three months is applied for internal reporting purposes. This concept
poses difficulty for the process of allocation of long-term costs. All the revenues and all the cost relating
to the year in operation have to be taken into account while matching the earnings and the cost of
those earnings for the any accounting period. This holds good irrespective of whether or not they have
been received in cash or paid in cash. Despite the difficulties which stem from this concept, short term
reports are of vital importance to owners, management, creditors and other interested parties. Hence,
the accountants have no option but to resolve such difficulties.
8. Cost Concept. Cost is taken to be the basis of accounting for all types of economic events occurring in
a business enterprise. It serves as the prime basis for values recorded and reported in the accounts and
ultimately in the financial statements. Items in the financial statements can be valued under a number
of bases. A basic principle of accounting is that items are normally stated in accounts at historical
cost, ie at the amount which the business paid to acquire them. An important advantage of this
procedure is that the objectivity of accounts is maximized: there is usually documentary evidence to
prove the amount paid to purchase an asset or pay an expense. The advantage of historical cost
accounting is that the cost is known and can be proved (eg by the invoice). There is no subjectivity or

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bias in the valuation. There are a number of disadvantages and these usually arise in times of rising
prices (inflation). When inflation is low, then historical cost accounting is usually satisfactory. However,
when inflation is high then problems can occur. Replacement cost means the amount needed to
replace an item with an identical item. Net realizable value is the expected price less any costs still to
be incurred in getting the item ready for sale and then selling it. Economic value is the value derived
from an asset's ability to generate income. A machine's economic value is the amount of profits it is
expected to generate for the remains of its useful life.
9. Realization Concept. Realization is technically understood as the process of converting non-cash
resources and rights into money. As accounting principle, it is used to identify precisely the amount of
revenue to be recognized and the amount of expense to be matched to such revenue for the purpose of
income measurement. The concept states that profits are realized immediately goods or services
exchange hands whether cash has been paid or not. According to realization concept, revenue is
recognized when the sale is made. In other words, revenue should be realized at the point of sale not
before. Sale is considered to be made at the point when the property in goods passes to the buyer and
he becomes legally liable to pay. This implies that revenue is generally realized when goods are
delivered, or services are rendered. The rationale is that delivery validates a claim against the
customer. However, in case of long run construction contracts revenue is often recognized on the basis
of a proportionate or partial completion method. Similarly, in case of long run instalment sales
contracts, revenue is regarded as realized only in proportion to the actual cash collection. In fact, both
these cases are the exceptions to the notion that an exchange is needed to justify the realization of
revenue.
10. Materiality Concept. Materiality concept states that items of small significance need not be given
strict theoretically correct treatment. Infact, there are many events in business which are insignificant
in nature. The cost of recording and showing in financial statement such events may not be well
justified by the utility derived from that information. In financial accounting, a matter is material if its
non-disclosure, misstatement, or omission would likely distort the view given by the accounts or other
statements under consideration, and thereby misleading the users. Matters regarded as immaterial do
not at all influence the decisions made by the information user. On the other hand, they may obscure
more significant information. In this connection, small items may be grouped up as bigger one (sundry
expenses) and figures may be rounded up to the nearest kwacha. This convention will unnecessarily
overburden an accountant with more details in case he is unable to find an objective distinction
between material and immaterial events. It should be noted that an item material for one party may be
immaterial for another. Actually, there are no hard and fast rule to draw the line between material and
immaterial events and hence, it is a matter of judgement and common sense. Despite this limitation, it

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is necessary to disclose all material information to make the financial statements clear and
understandable.
11. Conservatism Concept. This concept requires that the accountants must follow the policy of ‘’playing
it safe” while recording business transactions and events. That is why, the accountant follows the rule
to anticipate no profit but provide for all possible losses, while recording the business events. This rule
means that an accountant should record lowest possible value for assets and revenues, and the highest
possible value for liabilities and expenses. According to this concept, revenues or gains should be
recognized only when they are realized in the form of cash or assets (i.e. debts) the ultimate cash
realization of which can be assessed with reasonable certainty. Further, provision must be made for all
known liabilities, expenses and losses, probable losses regarding all contingencies should also be
provided for. ‘Valuing the stock in trade at market price or cost price whichever is less’, ‘making the
provision for doubtful debts on debtors in anticipation of actual bad debts’, ‘adopting written down
value method of depreciation as against straight line method’, not providing for discount on creditors
but providing for discount on debtors’, are some of the examples of the application of the convention of
conservatism. The principle of conservatism may also invite criticism if not applied cautiously. For
example, when the accountant creates secret reserves, by creating excess provision for bad and
doubtful debts, depreciation, etc. The financial statements do not present a true and fair view of state
of affairs. The revenue earnings of a business enterprise and its financial position must not be
overstated in financial statement. In conformity with this concept, closing stock is valued at the lower of
cost or the market value. Assets are written off promptly when doubt arises as to their value.
12. Prudence Concept. This concept states that accountants must exercise cautiousness when preparing
the financial statements. The prudence concept lays down that revenue and profits are not anticipated
but should only be recorded when earning is reasonably certain. Only realized profits are included in the
financial statements after all provisions are made for all loses. Expenses and liabilities should, however,
be recorded when anticipated, as best estimates if no actual figures are available. Loss in value of
assets, whether realized or not, should be recorded when it arises, but a gain in value of an asset
should not be recorded except via an unrealized reserve and only then if properly warranted. An
example of the application of the prudence concept is the requirement to value inventory at the lower
of cost and net realizable value. It states that incomes, assets, and gains should not be overstated.
While liabilities, expenses and losses should not be understated. It also argues that where alternative
procedures or alternative valuations are possible, the one selected should be the one which gives the
most cautious presentation of the business financial position or results. Prudence most obviously
conflicts with the accrual assumption because it requires that the matching of costs and revenues
should not take place if there is any doubt about the future recoverability of deferred costs. Prudence
also conflicts with the going concern assumption because it may not be prudent to assume that a

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business is a going concern (although it is realistic). Prudence makes it difficult to treat items
consistently because circumstances in one period may require a different treatment from previous
periods in order to be prudent. Prudence also undermines several other assumptions. For instance,
objectivity is regarded as important by most users of accounts but prudence (or conservatism as it is
sometimes called) implies a subjectivity in coming to accounting judgements. It is also difficult to
reconcile prudence with the use of anything other than the historical cost convention for valuing
assets.
13. Consistency Concept. The convention of consistency requires that once a firm decided on certain
accounting policies and methods and has used these for some time, it should continue to follow the
same methods or procedures for all subsequent similar events and transactions. unless it has a sound
reason to do otherwise. In other worlds, accounting practices should remain unchanged from one
period to another. For example, if depreciation is charged on fixed assets according to straight line
method, this method should be followed year after year. Analogously, if stock is valued at ‘cost or
market price whichever is less’, this principle should be applied in each subsequent year. However, this
principle does not forbid introduction of improved accounting techniques. If for valid reasons the
company makes any departure from the method so far in use, then the effect of the change must be
clearly stated in the financial statements in the year of change. The application of the principle of
consistency is necessary for the purpose of comparison. One could draw valid conclusions from the
comparison of data drawn from financial statements of one year with that of the other year. But the
inconsistency in the application of accounting methods might significantly affect the reported data. Any
policy changes should be disclosed to users together with the money effect on the overall reported
income of the year in which the change was made.
14. Substance over form. When identifying, measuring, and communicating financial information to
users, the information should reflect the realistic economic and financial realities and not merely their
legal form. It can happen that the legal form of a transaction can differ from its real substance, where
this happens accounting should show the transaction in accordance with its real substance e.g. goods
bought on hire purchase.

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