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3.5 - Accounting Concepts Used in The Preparation of Accounting Records
3.5 - Accounting Concepts Used in The Preparation of Accounting Records
Duality
Definition – This means that each financial transaction is recorded by the means of
two opposite entries (debit and credit), but of equal values.
Example – Double-entry bookkeeping
Cost
Definition – Assets and liabilities are recorded in the financial statements at historical
cost, i.e. the actual amount of the transaction involved. The benefit of that is that the
Statement of Financial Position valuations are objective – there can be no dispute
about the amounts shown. However, as time passes, historical cost valuations
become out-of-date and some businesses adopt a policy of regular revaluation of
assets.
Example – Freehold land and property bought, say, 20 years ago will have a much
higher value today than their cost price, so it makes sense for a business to carry out
revaluations from time-to-time.
Going concern
Definition – This presumes that the business to which the financial statements relate
will continue to trade in the foreseeable future. The income statement and Statement
of Financial Position are prepared on the basis that there is no intention to reduce the
size of a business significantly or to liquidate the business. If the business was not a
going concern, assets would have different values, and the Statement of Financial
Position would be affected considerably. The latter case is the opposite of the going
concern and could be described as a ‘gone concern’. Also, in a gone concern
situation, extra depreciation would need to be charged as an expense to income
statements to allow for the reduced value of non-current assets. Inventory valuation
which is usually on a going concern basis, would normally be much lower on a gone
concern basis.
Example – A large, purpose built factory has considerable value to a going concern
business but, if the factory had to sold, it is likely to have a limited use for other
industries, and therefore will have a lower market value.
Accruals
Definition – This means that expenses and income for goods and services are
matched to the same time period. The income statement shows the amount of the
expenses that should have been incurred, and the amount of income that should
have been received. This is the principle of income and expenditure accounting,
rather that using receipts and payments as they are received and paid.
Example – Examples of the accruals concept in accounting are:
Trade receivables
Trade payables
Depreciation of non-current assets
Irrecoverable debts written off
Provision for doubtful debts
Opening and closing inventory adjustments
Consistency
Definition – This requires that, when a business adopts particular accounting policies,
it should continue to use such policies consistently.
Example – A business that decides to make a provision for depreciation on
machinery at ten per cent a year, using straight line method, should continue to use
that percentage and method for future financial statements for this asset. Of course,
having once chosen a particular policy, a business is entitled to make changes
provided there are good reasons for doing so, and a note to the financial statements
would explain what has happened. By applying the consistency concept, directs
comparisons between the financial statements of different years can be made.
Futher examples of the consistency concept are:
Inventory valuation
Provision for doubtful debts
The application of the materiality concept
The treatment of capital and revenue expenditure
Prudence
Definition – This concept requires that caution be exercised when making
judgements under conditions of uncertainty. This means that, where there is any
doubt, a conservation (lower) figure for profit and the valuation of assets should be
reported. To this end, profits are not to be anticipated and should only be recognised
when it is reasonably certain that they will be actually made; at the same time all
know liabilities should be provided for. It should be noted that application of the
prudence concept requires careful judgement to be made when making estimates –
caution is needed to ensure that assets are not overstated, while liabilities and
expenses are not understated.
Example – Examples of the use of the prudence concept are:
Accruals of expenses and income, where an estimate is made of the amount
Prepayment of expenses and income, where an estimate is made of the
amount
Inventory valuation
Depreciation of non-current assets
Irrecoverable debts written off
Provision for doubtful debts
Materiality
Definition – Some items in accounts have such as low monetary (money) value that
is not worthwhile recording them separately, i.e. they are not ‘material’.
Example – Examples of this include:
Small expense items, such as donations to charities, the purchase of plants
for the office, window cleaning, etc, may not justify their own separate
expense account; instead they are grouped together in a sundry expense
account.
End-of-year quantities of office stationary, e.g. paper clips, staples,
photocopying paper, etc, are often not valued for the purpose of financial
statements, because the amount is not material and does not justify the time
and effort involved. This does mean, however, that the cost of all stationary
purchased during the year is charged as an expense to the income statement
– this is technically wrong, but it is not material enough to affect the financial
statements significantly.
Low-cost non-current assets are often charged as an expense in the income
statement, e.g. a stapler, waste-paper basket, etc. Theoretically, these should
be treated as non-current assets and depreciated each year other their
estimated life; in practice, because the amounts involved are not material they
are treated as income statement expenses.
Realisation
Definition – This concept states that the business transactions are recorded in the
financial statements when the legal title (ownership in law) passes between buyer
and seller. This may well not be at the same time as payment is made.
Example – Credit sales are recorded when the sale is made (which is when legal title
passes to the buyer), but the payment will be made at a later date. Likewise, goods
on sale or return are invoiced to the customer when they are supplied, but will be
either paid for or returned at a later date.
Business entity
Definition – This refers to the fact that financial statements record and report on the
activities of a particular business. They do not include the assets and liabilities of
people who play a part in owning or running the business.
Example – The personal assets and liabilities of the owner of a sole trader business
are kept separate from those of the business, and personal expenses (e.g. a family
holiday) cannot be paid for from the business bank account. The main links between
the business and the owner’s personal funds are capital and drawings.