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GAAP CONCEPTS

Lesson Learning Outcomes and Assessment Standards

20 Learning Outcome 1: Financial Information


The learner is able to demonstrate knowledge, understanding and the application of financial
information according to generally accepted accounting practice and concepts.
Assessment Standards:
We know this when the learner is able to:
• Define and explain accounting concepts for a sole trader up to the financial statements.
• Within the context of the accounting cycle, identify and complete source documents, record the
information in the subsidiary journals (books of first entry), post to the ledgers and draw up the
trial balance of a sole trader manually and/or by using an accounting package.
• Analyse and show the effect of transactions on the accounting equation of sole traders.
• Prepare final accounts and financial statements of a sole trader.

Overview
In this lesson, we look at the rules governing the accounting process, in particular
as determined by generally accepted accounting practice (GAAP).

Lesson
DVD The nature of GAAP
GAAP may be defined as the body of knowledge, consisting of the written and
unwritten rules of accounting, which guides accountants in their duty of financial
reporting. GAAP consists of various accounting concepts that will be further
discussed below.
The need for GAAP
The application of GAAP ensures that financial statements are:
● Understandable
● Useful
● Relevant
● Reliable
● Timely
● Verifiable
● Neutral
● Comparable and consistent.
The business entity concept
The financial affairs of a business are kept entirely separate from the financial
affairs of its owner. A business has a life distinct from that of its owner – the
owner’s personal expenses or income should not be recorded in the books of the
business, e.g. if the owner wins money in a casino, this forms part of his or her
personal income and not that of the business. Should personal income/expenses
be recorded in the books, confusion will arise and the financial statements will not
represent a true state of affairs.
The historical cost concept
This concept is based on the rule that assets will be valued at historical cost,
i.e. the amount which was originally paid for them (cost price). Land and
142 buildings which were acquired in 1990 for R90 000 will still be reflected in the
financial statements as R90 000 in the year 2000, even though the value may

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have doubled or even trebled since the purchase. The reason for this is that if
accountants were allowed to place any subjective value on assets, this could
result in manipulation of financial statements – financial results could either be
overstated or understated to suit their own purposes.
The going-concern cost concept
Financial statements are prepared on the assumption that a business will continue
operating for the foreseeable future. If a business had to suddenly close down, it
would be forced to value its assets at less than the values reflected in the books
– assets would realise a far lower value than their historical cost owing to the
forced closure of the business.
The matching concept
This concept has a two-sided effect:
● expenses and income must be recorded in the correct time period, and
● if an expense has been incurred with the effect of producing income, then these
two items must be matched against each other in the same set of financial
statements.
At financial year-end (e.g. 28 February 20.4) all transactions up to and including
this date must be reflected in the financial statements on 28 February 20.4. This
would include expenses which have not yet been paid and income which has not
yet been received up to and including 28 February 20.4. This concept therefore
implies that income and expenses are recorded when they are incurred and not
when they are actually received or paid. The reason for this is to ensure that
financial statements are comparable from one year to the next year and from one
business to another.
The prudence concept
This concept is based on the assumption that financial results are presented in a
conservative manner, possibly even in a pessimistic manner. An accountant will
not consider any expected income, but will make provision for anticipated losses
even if he or she is not entirely certain of the exact amount. An accountant would
understate rather than overstate profits in the event of uncertainty.
The concept of materiality
This concept covers the disclosure of items which are of importance to readers of
financial statements – only material items are shown in the financial statements.
The reason for this is to assist the readers of financial statements in their
understanding of the figures provided. Financial statements are not cluttered with
long lists of figures – only the relevant information is shown. The other details are
usually shown separately as a note to the financial statements.
In preparing the financial statements, it is necessary to adjust figures at the end of
the financial period. Consider the table below.
Required
You are required to match the examples in the left-hand column with the
appropriate concepts in the right-hand column.

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Table:
Examples of year-end adjustments Appropriate principle applied
A. Damages payable to a client will be finalised
next year. An estimated amount of R9 000 is 1. Business entity principle
recorded this year.
B. Interest on overdraft is shown as a separate
2. Historical cost principle
amount to Interest on loan.
C. An owner owes his sister R5 000 for costs
incurred on holiday. This is not reflected in 3. Going-concern principle
the financial statements of the business.
D. When a debtor settles his or her account,
the discount granted must be recorded at the 4. Matching principle
same time.
E. Land and buildings are shown in the
financial statements at R400 000, even
5. Principle of prudence
though an estate agent says the property is
worth twice that amount.
F. Trading stock is still shown at the cost price
of R20 000, even though it could only be
6. Principle of materiality
sold immediately for R15 000 on a flea
market or auction.

State the concept applied in each of the following cases:


Interest on overdraft is shown separately from bank charges in the income
statement.
The financial period is 01 March 20.4 – 28 February 20.5. Part of the shop is let
at a monthly rental of R12 000 per annum, but the tenant has not yet paid the
rent for February 20.5. R12 000 was recorded in the income statement on
28 February 20.5.
The owner won the National Lotto. He did not record this as income in the income
statement of his business.
Land and buildings of a business are reflected in the balance sheet at R250 000,
yet the owner has been offered R450 000.
Consumable stores have been ordered in the current financial year, but will only be
delivered early in the next financial year.
Obsolete computers are valued at R15 000 in the balance sheet even though the
business could only get R5 000 if it were to sell these to its staff immediately.
Stock of merchandise worth R25 000 and consumables worth R5 000 are
reflected in the balance sheet as inventory at R30 000. The break-down is shown
separately as a note to the financial statements.
An amount in respect of damages is owing to a customer. The amount will be
finalised in the next financial year. The accountant estimated the damages at
R20 000 and recorded it in the current financial year.
The interest on the loan for the current year amounted to R5 000. Only R3 000
was paid. The income statement for the current year reflected an amount of
R5 000 in respect of the interest.
Stationery, consumables and repairs have been grouped under “Sundry expenses”.
Year-end accounting procedures
After all posting to the general ledger has been processed, a trial balance is drawn
up. This is done to verify that the double-entry principle has been adhered to
and all posting has been done correctly. The trial balance does not indicate how
144 profitable the business is – it merely consists of a list of balances of the various
ledger accounts in the general ledger. In order to determine the profitability of a

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business, a new set of accounts needs to be prepared, namely the trading account
and the profit and loss account.
Although a business is run as a going concern, it is essential to prepare final
accounts for a stated period, e.g. 01 March 20.4 – 28 February 20.5. This period
is called the financial year or accounting period. It should be noted that a business
does not have to follow the calendar year, i.e. 01 January 20.4 – 31 December
20.4. Most businesses use the financial period of 01 March 20.4 – 28 February
20.5, mainly for tax reasons.
Before final accounts are drawn up, it is necessary to take adjustments into
account. Adjustments consist of entries which were not considered when the
trial balance was drawn up. Examples of these adjustments are dealt with below.
Adjustments are made to ensure that the matching concept is complied with
– expenses and income are matched for the same time-frame. The double-entry
principle applies to adjustments. Adjustments are recorded by means of journal
entries. Postings are done to the relevant accounts and an adjusted trial balance is
drawn up. This trial balance is called the post-adjustment trial balance. The trial
balance that is drawn up before adjustments have been considered, is called the
pre-adjustment trial balance.
YEAR END PROCEDURES:

Pre-adjustment
trial balance
Journal entries
for
adjustments

Post
to the
ledger

Post-adjustment
trial balance

Activity 1
Match each concept mentioned in the left-hand column with an example of its Individual
application in the right-hand column.
formative
N.B. assessment
In your answer book, record the concepts on the left with the correct responses in
the right-hand column.
CONCEPTS APPLICATION
(A) (1)
Business entity concept Damages payable to a client will be finalised next year. An estimated
amount of R15 000 is recorded this year.
(B) (2)
Historical cost concept Interest on overdraft is shown as a separate amount in the income
statement.
(C) (3)
Going-concern concept An owner of a business wins R1 000 in a competition. This is not
reflected in the income statement of the business.
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(D) (4)
Matching concept Whenever a debtor settles an account, discounts should be recorded
at the same time.
(E) (5)
Prudence concept Land and buildings are shown in the balance sheet at R105 000,
even though an estate agent says that they could be sold for
R250 000.
(F) (6)
Concept of materiality Trading stock is shown in the balance sheet at R80 000, even though
the business would get only R50 000 if the stock was sold at a flea
market the next day.

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