Question No 1 - MMPC 004 - Accounting for Managers - MBA and MBA (Banking & Finance)

 

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                            MBA and MBA (Banking & Finance)

MMPC 004 - Accounting for Managers

MMPC-004/TMA/JULY/2022

Question No. 1. Explain the following accounting concepts 
(a) Business Entity concept 
(b) Money measurement concept 
(c) Continuity concept 
(d) Accrual concept 

Solution:

a) Business Entity concept

The business entity concept states that the transactions associated with a business must be separately recorded from those of its owners or other businesses. Doing so requires the use of separate accounting records for the organization that completely exclude the assets and liabilities of any other entity or the owner. Without this concept, the records of multiple entities would be intermingled, making it quite difficult to discern the financial or taxable results of a single business. Here are several examples of the business entity concept:

• A business issues a $1,000 distribution to its sole shareholder. This is a reduction in equity in the records of the business, and $1,000 of taxable income to the shareholder.

• The owner of a company personally acquires an office building, and rents space in it to his company at $5,000 per month. This rent expenditure is a valid expense to the company, and is taxable income to the owner.

• The owner of a business loans $100,000 to his company. This is recorded by the company as a liability, and by the owner as a loan receivable.

There are many types of business entities, such as sole proprietorships, partnerships, corporations, and government entities.
Reasons for the Business Entity Concept
There are a number of reasons for the business entity concept, including the need to separately track taxes, financial performance, and financial position for each entity. It is also useful for when an organization is liquidated, to determine the amounts of payouts to the various owners. Further, the business entity concept is needed from a liability perspective, to ascertain the assets available in the event of a legal judgment against a business entity. And finally, it is not possible to audit the records of a business if the records have been combined with those of other entities and/or individuals.

Importance of Business Entity Concept in Accounting

Business entity concept is important in accounting for the following reasons:
1. The business entity concept is very important as it helps to measure the performance of a business separate from its owner and on different parameters such as cash flows, profitability, etc.
2. If the business organisation record mixes with the records of the business owners, it creates an inaccurate representation of the financial position of business. The business entity concept helps in preventing such an issue.
3. It helps the business in comparison of financial performance with other business organisations.
4. It helps in calculation of separate taxes for the business and its owners.
5. It helps in ascertaining the value of the assets and liabilities of a business in the event of any legal action taken against the business.

b) Money Measurement Concept

The money measurement concept states that a business should only record an accounting transaction if it can be expressed in terms of money. This means that the focus of accounting transactions is on quantitative information, rather than on qualitative information. Thus, a large number of items are never reflected in a company's accounting records, which means that they never appear in its financial statements. Examples of items that cannot be recorded as accounting transactions because they cannot be expressed in terms of money include:

• Employee skill level
• Employee working conditions
• Expected resale value of a patent
• Value of an in-house brand
• Product durability
• The quality of customer support or field service
• The efficiency of administrative processes

All of the preceding factors are indirectly reflected in the financial results of a business, because they have an impact on either revenues, expenses, assets, or liabilities. For example, a high level of customer support will likely lead to increased customer retention and a higher propensity to buy from the company again, which therefore impacts revenues. Or, if employee working conditions are poor, this leads to greater employee turnover, which increases labor-related expenses.

Problems with the Money Measurement Concept
The key flaw in the money measurement concept is that many factors can lead to long-term changes in the financial results or financial position of a business (as just noted), but the concept does not allow them to be stated in the financial statements. The only exception would be a discussion of pertinent items that management includes in the disclosures that accompany the financial statements. Thus, it is entirely possible that the key underlying advantages of a business are not disclosed, which tends to under-represent the long-term ability of a business to generate profits. The reverse is typically not the case, since management is encouraged by the accounting standards to disclose all current or potential liabilities in the notes accompanying the financial statements. In short, the money measurement concept can lead to the issuance of financial statements that may not adequately represent the future upside of a business. However, if this concept were not in place, managers could flagrantly add intangible assets to the financial statements that have little supportable basis.

Importance of Money Measurement Concept
As money is regarded as a common unit of recording transactions related to the income, profit, loss, capital, assets and liabilities of a business, it becomes easier to record and present business transactions into the financial statements such as Profit and Loss statement and Balance Sheet.

Advantages of Money Measurement Concept
Following are some of the advantages of the money measurement concept
1. It helps in maintaining business records by recording all transactions that are having monetary value.
2. It is helpful in preparation of financial statements (such as Profit and Loss Statement, Income Statement)
3. As the financial transactions are recorded in a proper manner, it becomes easy when two separate accounting periods are compared.
4. It provides a clear picture of the financial transactions and state of the business which help in assessing the investors in knowing the status of their investment.

c) Continuity Concept

• This concept facilitates preparation of financial statements. 

• On the basis of this concept, depreciation is charged on the fixed asset. 

• It is of great help to the investors, because, it assures them that they will continue to get income on their investments. 

• In the absence of this concept, the cost of a fixed asset will be treated as an expense in the year of its purchase. 

• A business is judged for its capacity to earn profits in future.

Importance of Going Concern Concept in Accounting

This concept states that a business firm will continue to carry on its activities for an indefinite period of time. Simply stated, it means that every business entity has continuity of life. Thus, it will not be dissolved in the near future. This is an important assumption of accounting, as it provides a basis for showing the value of assets in the balance sheet; For example, a company purchases a plant and machinery of Rs.100000 and its life span is 10 years. According to this concept every year some amount will be shown as expenses and the balance amount as an asset. Thus, if an amount is spent on an item which will be used in business for many years, it will not be proper to charge the amount from the revenues of the year in which the item is acquired. Only a part of the value is shown as expense in the year of purchase and the remaining balance is shown as an asset. 

Significance 

The following points highlight the significance of going concern concept; 

Going concern concept is very important for the generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). The concept of going concern plays a significant role in the way assets are treated.

The concept of depreciation and amortization are based on the assumption that a business will continue to perform its operations in the near future (this period is the next 12 months after an accounting period).

Advantages of Going Concern Concept

Following are some of the advantages of the going concern concept

1.Companies during the formation years will be purchasing fixed assets that will be requiring expenditure upfront, but such assets will be providing the benefits spread over a long term, that is well beyond one accounting period. Therefore, the going concern concept provides a way to record the value of such assets.

2. It is the basis on which the profits and losses of the business are recorded for the year to which it belongs.

Disadvantages of Going Concern Concept

Listed below are some of the disadvantages of the going concern concept:

1. Financial statements are prepared at cost and not on the basis of current market value. In such a case, if the company in an event of liquidation, will have assets valued at the market value, and as such these values will be different from the value determined at cost.

2. In the event of business being liquidated, the financial statements will be calculated on the on going concern basis, which can be misleading for the stakeholders.

d) Accrual Concept

The meaning of accrual is something that becomes due especially an amount of money that is yet to be paid or received at the end of the accounting period. It means that revenues are recognised when they become receivable. Though cash is received or not received and the expenses are recognised when they become payable though cash is paid or not paid. Both transactions will be recorded in the accounting period to which they relate. Therefore, the accrual concept makes a distinction between the accrual receipt of cash and the right to receive cash as regards revenue and actual payment of cash and obligation to pay cash as regards expenses. 

The accrual concept under accounting assumes that revenue is realised at the time of sale of goods or services irrespective of the fact when the cash is received. For example, a firm sells goods for Rs 55000 on 25th March 2005 and the payment is not received until 10th April 2005, the amount is due and payable to the firm on the date of sale i.e. 25th March 2005. It must be included in the revenue for the year ending 31st March 2005. Similarly, expenses are recognised at the time services provided, irrespective of the fact when actual payment for these services are made. For example, if the firm received goods costing Rs.20000 on 29th March 2005 but the payment is made on 2nd April 2005 the accrual concept requires that expenses must be recorded for the year ending 31st March 2005 although no payment has been made until 31st March 2005 though the service has been received and the person to whom the payment should have been made is shown as creditor. In brief, accrual concept requires that revenue is recognised when realised and expenses are recognised when they become due and payable without regard to the time of cash receipt or cash payment.

Advantages of Accrual Basis of Accounting

The following are some of the advantages of accrual basis of accounting.

1. It helps the businesses in realising the true profit by providing a more realistic representation of the business.

2. Businesses that use an accrual basis of accounting are seen as more reliable than those using a cash basis method.

3. Auditing of financial statements is possible only when accrual basis is chosen as the method of accounting.

4. It allows for easy planning as the business accounts for all the revenues and expenses that will occur during the accounting period and prepare a budget accordingly.

Disadvantages of Accrual basis of Accounting

Following are some of the disadvantages of accrual basis of accounting:

1. Accrual basis of accounting can be complicated requiring more skill, time and resources.

2. It can give a skewed view of the short term financial position of the company.