Accounting Concepts, Bases and Policies

Accounting Concepts are broad basic assumptions that underlie the periodic financial accounts of
business enterprises. They include:

1) The Going Concern Concept:

It implies that the business will continue in operational existence for the foreseeable future, and that
there is no intention to put the company into liquidation or to make drastic cutbacks to the scale of
operations.
Financial statements should be prepared under the going concern basis unless the entity is being (or is
going to be) liquidated or if it has ceased (or is about to cease) trading. The directors of a company
must also disclose any significant doubts about the company’s future if and when they arise.
The main significance of the going concern concept is that the assets of the business should not be
valued at their ‘break-up’ value, which is the amount that they would sell for it they were sold off
piecemeal and the business were thus broken up.
2) The Accruals (Matching) Concept:
It states that revenue and costs must be recognized as they are earned or incurred, not as money is
received or paid. They must be matched with one another so far as their relationship can be
established or justifiably assumed, and dealt with in the profit and loss account of the period to which
they relate.
Essentially, the accruals concept states that, in computing profit, revenue earned must be matched
against the expenditure incurred in earning it.

What this means is that the time when the revenue is received or the expense is incurred is
completely disregarded. This leads into two scenarios; prepayments and accruals. Prepayments occur
when money is received for a period that it has yet to be earned, or an expense is paid for but has not
yet been incurred. Accruals occur when the expense for the money is being paid for has already been
incurred i.e. the expense belongs to a past period, or when an income is received way after the period
of earning has expired.
3) The Prudence Concept:
The prudence concept states that where alternative procedures, or alternative valuations, are
possible, the one selected should be the one that gives the most cautious presentation of the
business’s financial position or results. Therefore, revenue and profits are not anticipated but are
recognized by inclusion in the profit and loss account only when realized in the form of either cash or
of other assets the ultimate cash realization of which can be assessed with reasonable certainty. A
provision is made for all liabilities (expenses and losses) whether the amount of these is known with
certainty or is best estimate in the light of the information available.

Assets and profits should not be overstated, but a balance must be achieved to prevent the material
overstatement of liabilities or losses. The other aspect of the prudence concept is that where a loss is
foreseen, it should be anticipated and taken into account immediately. If a business purchases stock
for KES 1,200 but because of a sudden slump in the market only KES 900 is likely to be realized when
the stock is sold, the prudence concept dictates that the stock should be valued at KES 900. It is not
enough to wait until the stock is sold, and then recognize the KES300 loss; it must be recognized as
soon as it is foreseen.
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 A profit can be considered to be a realized profit when it is in the form of:
 Cash
 Another asset that has a reasonably certain cash value. This includes amounts owing from
debtors, provided that there is a reasonable certainty that the debtors will eventually pay up
what they owe.
4) The Consistency Concept: The consistency concept states that in preparing accounts consistency
should be observed in two respects.

a) Similar items within a single set of accounts should be given similar accounting treatment.
b) The same treatment should be applied from one period to another in accounting for similar
items. This enables valid comparisons to be made from one period to the next.
5) The Business Entity Concept:
The individual business unit is the business entity for which economic data are needed. The concept is
that accountants regard a business as a separate entity, distinct from its owners or managers. The
concept applies whether the business is a limited company (and so recognized in law as a separate
entity) or a sole proprietorship or partnership (in which case the business is not separately recognized
by the law. This concept is important because it limits the economic data in the accounting system to
the data directly related to the activities of the business.
6) The Money Measurement Concept:
The money measurement concept states that accounts will only deal with those items to which a
monetary value can be attributed. E.g. in the balance sheet of a business, monetary values can be
attributed to such assets as machinery (e.g. the original cost of the machinery; or the amount it would
cost to replace the machinery) and stocks of goods (e.g. the original cost of goods, or, theoretically,
the price at which the goods are likely to be sold).
The monetary measurement concept introduces limitations to the subject matter of accounts. A
business may have intangible assets such as the flair of a good manager or the loyalty of its workforce.
These may be important enough to give it a clear superiority over an otherwise identical business, but
because they cannot be evaluated in monetary terms they do not appear anywhere in the accounts.
7) The Separate Valuation Principle:
The separate valuation principle states that, in determining the amount to be attributed to an asset or
liability in the balance sheet, each component item of the asset or liability must be determined
separately. These separate valuations must then be aggregated to arrive at the balance sheet figure.
For example, if a company’s stock of goods comprises 50 separate items, a valuation must (in theory)
be arrived at for each item separately; the 50 figures must then be aggregated and the total is the
stock figure which should appear in the balance sheet.
8) The materiality concept:
An item is considered material if it’s omission or misstatement will affect the decision making process
of the users. Materiality depends on the nature and size of the item. Only items material in amount or
in their nature will affect the true and fair view given by a set of accounts. An error that is too trivial to
affect anyone’s understanding of the accounts is referred to as immaterial. In preparing accounts it is
important to assess what is material and what is not, so that time and money are not wasted in the
pursuit of excessive detail.

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 Determining whether or not an item is material is a very subjective exercise. There is no absolute
measure of materiality. But some items disclosed in accounts are regarded as particularly sensitive
and even a very small misstatement of such an item would be regarded as a material error. An
example in the accounts of a limited company might be the amount of remuneration paid to directors
of the company. The assessment of an item as material or immaterial may affect its treatment in the
accounts. For example, the profit and loss account of a business will show the expenses incurred by
the business grouped under suitable captions (heating and lighting expenses, rent and rates expenses
etc.); but in the case of very small expenses it may be appropriate to lump them together under a
caption such as ‘sundry expenses’, because a more detailed breakdown would be inappropriate for
such immaterial amounts.
Example:
a) If a balance sheet shows fixed assets of KES 2 million and stocks of KES 30,000 an error of KES 2,000
in the depreciation calculations might not be regarded as material, whereas an error of KES 20,000
in the stock valuation probably would be. In other words, the total of which the erroneous item
forms part must be considered.
b) If a business has a bank loan of KES 50,000 balance and a KES 55,000 balance on bank deposit
account, it might well be regarded as a material misstatement if these two amounts were displayed
on the balance sheet as ‘cash at bank KES 5,000’. In other words, incorrect presentation may
amount to material misstatement even if there is no monetary error.
9) The Historical Cost Convention:
A basic principle of accounting is that resources are normally stated in accounts at historical cost, i.e.
at the amount that the business paid to acquire them. An important advantage of this procedure is
that the objectivity of accounts is maximized: there is usually objective, documentary evidence to
prove the amount paid to purchase an asset or pay an expense. Historical cost means transactions are
recorded at the cost when they occurred. In general, accountants prefer to deal with costs, rather
than with ‘values’. This is because valuations tend to be subjective and to vary according to what the
valuation is for.
10) The Realization Concept:
Realization means that Revenue and profits are recognized when realized. The concept states that
revenue and profits are not anticipated but are recognized by inclusion in the income statement only
when realized in the form of either cash or of other assets the ultimate cash realization of which can
be assessed with reasonable certainty.

11) Duality: Every transaction has two-fold effect in the accounts and is the basis of double entry
bookkeeping.

12) Substance over Form:

The principle that transactions and other events are accounted for and presented in accordance with
their substance and economic reality and not merely their legal form e.g. a non-current asset on Hire
purchase although is not legally owned by the enterprise until it is fully paid for, it is reflected in the
accounts as an asset and depreciation provided for in the normal accounting way.

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Bases
Bases are the methods that have been developed for expressing or applying fundamental accounting
concepts to financial transactions and items. Examples include:
 Depreciation of Non-current Assets (e.g. by straight line or reducing balance method)
 Treatment and amortization of intangible assets (patents and trademarks)
 Stocks and work in progress Valuation methods (FIFO, LIFO and AVCO).

Policies
Accounting policies are the specific accounting bases judged by business enterprises to be the most
appropriate to their circumstances and adopted by them for the purpose of preparing their financial
accounts.
Qualities of Useful Financial Information
Relevance
Relevant financial information is capable of making a difference in the decisions made by users. Financial
information is capable of making a difference in decisions if it has predictive value, confirmatory value,
or both. The predictive value and confirmatory value of financial information are interrelated.

Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or both) of the
items to which the information relates in the context of an individual entity's financial report.

Faithful representation
General purpose financial reports represent economic phenomena in words and numbers. To be useful,
financial information must not only be relevant, it must also represent faithfully the phenomena it
purports to represent. This fundamental characteristic seeks to maximise the underlying characteristics
of completeness, neutrality and freedom from error. Information must be both relevant and faithfully
represented if it is to be useful.

Enhancing qualitative characteristics

Comparability, verifiability, timeliness and understandability are qualitative characteristics that enhance
the usefulness of information that is relevant and faithfully represented.

Comparability
Information about a reporting entity is more useful if it can be compared with a similar information
about other entities and with similar information about the same entity for another period or another
date. Comparability enables users to identify and understand similarities in, and differences among,
items.

Verifiability
Verifiability helps to assure users that information represents faithfully the economic phenomena it
purports to represent. Verifiability means that different knowledgeable and independent observers
could reach consensus, although not necessarily complete agreement, that a particular depiction is a
faithful representation.

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Timeliness
Timeliness means that information is available to decision-makers in time to be capable of influencing
their decisions.

Understandability
Classifying, characterizing and presenting information clearly and concisely makes it understandable.
While some phenomena are inherently complex and cannot be made easy to understand, to exclude
such information would make financial reports incomplete and potentially misleading. Financial reports
are prepared for users who have a reasonable knowledge of business and economic activities and who
review and analyse the information with diligence i.e. users are assumed to have a reasonable
knowledge of business and economic activities and accounting.

Reliability:
Information is useful when it is free from material error and bias and can be depended upon by users to
represent faithfully that which it purports to represent or could reasonably be expected to represent.
To be reliable then the information should:

a) Be represented faithfully,
b) Be accounted for and presented in accordance with their substance and economic reality and not
merely their legal form,
c) Be neutral i.e. free from bias,
d) Include some degree of caution especially where uncertainties surround some events and
transactions (prudence),
e) Be complete i.e. must be within the bounds of materiality and cost. An omission can cause
information to be false.

Applying the enhancing qualitative characteristics

Enhancing qualitative characteristics should be maximised to the extent necessary. However, enhancing
qualitative characteristics (either individually or collectively) cannot render information useful if that
information is irrelevant or not represented faithfully.

Ethical Standards of Accountants.

Accountants have an obligation to the organization they serve, the profession, the public, and
themselves to maintain the highest standards of ethical behavior. There are five fundamental principles
of ethics for professional accountants:

a) Professional Competence and Due Care – to:

(i) Attain and maintain professional knowledge and skill at the level required to ensure that a client
or employing organization receives competent professional service, based on current technical
and professional standards and relevant legislation
(ii) Act diligently and in accordance with applicable technical and professional standards.
b) Objectivity – not to compromise professional or business judgements because of bias, conflict of
interest or undue influence of others.

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c) Confidentiality – to respect the confidentiality of information acquired as a result of professional and
business relationships.
d) Professional Behavior – to comply with relevant laws and regulations and avoid any conduct that the
professional accountant knows or should know might discredit the profession.
e) Integrity – to be straightforward and honest in all professional and business relationships.

A professional accountant shall comply with each of the fundamental principles.

A professional accountant might face a situation in which complying with one fundamental principle
conflicts with complying with one or more other fundamental principles. In such a situation, the
accountant might consider consulting, on an anonymous basis if necessary, with:
 Others within the firm or employing organization.
 Those charged with governance.
 A professional body.
 A regulatory body.
 Legal counsel.

However, such consultation does not relieve the accountant from the responsibility to exercise
professional judgment to resolve the conflict or, if necessary, and unless prohibited by law or regulation,
disassociate from the matter creating the conflict.
The professional accountant is encouraged to document the substance of the issue, the details of any
discussions, the decisions made and the rationale for those decisions.

a) Professional Competence and Due Care

1. A professional accountant shall comply with the principle of professional competence and due care,
which requires an accountant to:
2. Attain and maintain professional knowledge and skill at the level required to ensure that a client or
employing organization receives competent professional service, based on current technical and
professional standards and relevant legislation; and
3. Act diligently and in accordance with applicable technical and professional standards.
4. Serving clients and employing organizations with professional competence requires the exercise of
sound judgment in applying professional knowledge and skill when undertaking professional
activities.
5. Maintaining professional competence requires a continuing awareness and an understanding of
relevant technical, professional and business developments. Continuing professional development
enables a professional accountant to develop and maintain the capabilities to perform competently
within the professional environment.
6. Diligence encompasses the responsibility to act in accordance with the requirements of an
assignment, carefully, thoroughly and on a timely basis.
7. In complying with the principle of professional competence and due care, a professional accountant
shall take reasonable steps to ensure that those working in a professional capacity under the
accountant’s authority have appropriate training and supervision.
8. Where appropriate, a professional accountant shall make clients, the employing organization, or
other users of the accountant’s professional services or activities, aware of the limitations inherent
in the services or activities.

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b) Objectivity
1. A professional accountant shall comply with the principle of objectivity, which requires an
accountant not to compromise professional or business judgment because of bias, conflict of
interest or undue influence of others.
2. A professional accountant shall not undertake a professional activity if a circumstance or
relationship unduly influences the accountant’s professional judgment regarding that activity.
3. A professional accountant shall disclose fully all the relevant information that would reasonably be
expected to influence unintended users’ understanding of the reports, comments, and
recommendations.
c) Confidentiality
1. A professional accountant shall comply with the principle of confidentiality, which requires an
accountant to respect the confidentiality of information acquired as a result of professional and
business relationships. An accountant shall:
a) Be alert to the possibility of inadvertent disclosure, including in a social environment, and
particularly to a close business associate or an immediate or a close family member;
b) Maintain confidentiality of information within the firm or employing organization;
c) Maintain confidentiality of information disclosed by a prospective client or employing
organization;
d) Not disclose confidential information acquired as a result of professional and business
relationships outside the firm or employing organization without proper and specific authority,
unless there is a legal or professional duty or right to disclose;
e) Not use confidential information acquired as a result of professional and business relationships
for the personal advantage of the accountant or for the advantage of a third party;
f) Not use or disclose any confidential information, either acquired or received as a result of a
professional or business relationship, after that relationship has ended; and
g) Take reasonable steps to ensure that personnel under the accountant’s control, and individuals
from whom advice and assistance are obtained, respect the accountant’s duty of confidentiality.

2. Confidentiality serves the public interest because it facilitates the free flow of information from the
professional accountant’s client or employing organization to the accountant in the knowledge that
the information will not be disclosed to a third party. Nevertheless, the following are circumstances
where professional accountants are or might be required to disclose confidential information or
when such disclosure might be appropriate:
a) Disclosure is required by law, for example:
i) Production of documents or other provision of evidence in the course of legal proceedings; or
ii) Disclosure to the appropriate public authorities of infringements of the law that come to
light;
b) Disclosure is permitted by law and is authorized by the client or the employing organization; and
c) There is a professional duty or right to disclose, when not prohibited by law:
(i) To comply with the quality review of a professional body;
(ii) To respond to an inquiry or investigation by a professional or regulatory body;
(iii) To protect the professional interests of a professional accountant in legal proceedings; or
(iv) To comply with technical and professional standards, including ethics
requirements.

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3. In deciding whether to disclose confidential information, factors to consider, depending on the
circumstances, include:
a) Whether the interests of any parties, including third parties whose interests might be affected, could
be harmed if the client or employing organization consents to the disclosure of information by the
professional accountant.
b) Whether all the relevant information is known and substantiated, to the extent practicable. Factors
affecting the decision to disclose include:
(i) Unsubstantiated facts.
(ii) Incomplete information.
(iii) Unsubstantiated conclusions.
c) The proposed type of communication, and to whom it is addressed.
d) Whether the parties to whom the communication is addressed are appropriate recipients.
4. A professional accountant shall continue to comply with the principle of confidentiality even after
the end of the relationship between the accountant and a client or employing organization. When
changing employment or acquiring a new client, the accountant is entitled to use prior experience
but shall not use or disclose any confidential information acquired or received as a result of a
professional or business relationship.
d) Professional Behavior
1. A professional accountant shall comply with the principle of professional behavior, which requires
an accountant to comply with relevant laws and regulations and avoid any conduct that the
accountant knows or should know might discredit the profession. A professional accountant shall
not knowingly engage in any business, occupation or activity that impairs or might impair the
integrity, objectivity or good reputation of the profession, and as a result would be incompatible
with the fundamental principles.
2. Conduct that might discredit the profession includes conduct that a reasonable and informed third
party would be likely to conclude adversely affects the good reputation of the profession.
3. When undertaking marketing or promotional activities, a professional accountant shall not bring the
profession into disrepute. A professional accountant shall be honest and truthful and shall not
make:
(i) Exaggerated claims for the services offered by, or the qualifications or experience of, the
accountant; or
(ii) Disparaging references or unsubstantiated comparisons to the work of others.
4. If a professional accountant is in doubt about whether a form of advertising or marketing is
appropriate, the accountant is encouraged to consult with the relevant professional body.
e) Integrity
1. A professional accountant shall comply with the principle of integrity, which requires an accountant
to be straightforward and honest in all professional and business relationships. Integrity implies fair
dealing and truthfulness.
2. A professional accountant shall not knowingly be associated with reports, returns, communications
or other information where the accountant believes that the information:
(i) Contains a materially false or misleading statement;
(ii) Contains statements or information provided recklessly; or
(iii) Omits or obscures required information where such omission or obscurity would be misleading.
3. If a professional accountant provides a modified report in respect of such a report, return,
communication or other information, the accountant is not in breach of (2).
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4. When a professional accountant becomes aware of having been associated with information
described in (2), the accountant shall take steps to be disassociated from that information.
5. A professional accountant shall avoid actual or apparent conflict of interest and advise all the
appropriate parties of any potential conflict.
6. A professional accountant shall refrain from engaging in any activity that would prejudice their
ability to carry out their duties ethically.
7. A professional accountant shall refuse any gift, favor, or hospitality that could influence or appear to
influence their actions.
8. A professional accountant shall communicate favorable and unfavorable information and
professional opinions.