Accounting Concepts Bases and Policies

Concepts/conventions/principles

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

The going concern concept

The going concern concept 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.

The accruals concept (or matching concept):

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.

Assume that a firm makes a profit of 100 by matching the revenue (200) earned from the sale of 20 units against the cost (100) of acquiring them.

If, however, the firm had only sold eighteen units, it would have been incorrect to charge profit and loss account with the cost of twenty units; there is still two units in stock.  If the firm intends to sell them later, it is likely to make a profit on the sale.  Therefore, only the purchase cost of eighteen units (90) should be matched with the sales revenue, leaving a profit of 90.

The balance sheet would therefore look like this:

If, however the firm had decided to give up selling units, then the going concern concept would no longer apply and the value of the two units in the balance sheet would be a break-up valuation rather than cost.  Similarly, if the two unsold units were now unlikely to be sold at more than their cost of £5 each (say, because of damage or a fall in demand) then they should be recorded on the balance sheet at their net realizable value (i.e. the likely eventual sales price less any expenses incurred to make them saleable, e.g. paint) rather than cost.  This shows the application of the prudence concept.  (See below).

In this example, the concepts of going concern and matching are linked.  Because the business is assumed to be a going concern it is possible to carry forward the cost of the unsold units as a charge against profits of the next period.

Essentially, the accruals concept states that, in computing profit, revenue earned must be matched against the expenditure incurred in earning it.

1. 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:  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 £1,200 but because of a sudden slump in the market only £900 is likely to be realized when the stock is sold the prudence concept dictates that the stock should be valued at £900.  It is not enough to wait until the stock is sold, and then recognize the £300 loss; it must be recognized as soon as it is foreseen.

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.

A company begins trading on 1 January 20X2 and sells goods worth £100,000 during the year to 31 December.  At 31 December there are debts outstanding of £15,000.  Of these, the company is now doubtful whether £6,000 will ever be paid.

The company should make a provision for doubtful debts of £6,000.  Sales for 20×5 will be shown in the profit and loss account at their full value of £100,000, but the provision for doubtful debts would be a charge of £6,000.  Because there is some uncertainty that the sales will be realized in the form of cash, the prudence concept dictates that the £6,000 should not be included in the profit for the year.

1. The consistency concept: The consistency concept states that in preparing accounts consistency should be observed in two respects.

1. Similar items within a single set of accounts should be given similar accounting treatment.
2. 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.

1. The entity concept: 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.

1. 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.

For example, 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.

1. 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 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.

1. 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.

Determining whether or not an item is material is a very subjective exercise.  There is no absolute measure of materiality.  It is common to apply a convenient rule of thumb (for example to define material items as those with a value greater than 5% of the net profit disclosed by the accounts).  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 he 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:

1. If a balance sheet shows fixed assets of 2 million and stocks of 30,000 an error of 20,000 in the depreciation calculations might not be regarded as material, whereas an error of 20,000 in the stock valuation probably would be.  In other words, the total of which the erroneous item forms part must be considered.
2. If a business has a bank loan of 50,000 balance and a 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 5,000’.  In other words, incorrect presentation may amount to material misstatement even if there is no monetary error.

1. The historical cost convention: A basic principle of accounting (some writers include it in the list of fundamental accounting concepts) 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.  For example, suppose that a company acquires a machine to manufacture its products.  The machine has an expected useful life of four years.  At the end of two years the company is preparing a balance sheet and has decided what monetary amount to attribute to the asset.

1. Objectivity (neutrality): An accountant must show objectivity in his work.  This means he should try to strip his answers of any personal opinion or prejudice and should be as precise and as detailed as the situation warrants.  The result of this should be that any number of accountants will give the same answer independently of each other. Objectivity means that accountants must be free from bias.  They must adopt a neutral stance when analysing accounting data. In practice objectivity is difficult.  Two accountants faced with the same accounting data may come to different conclusions as to the correct treatment.  It was to combat subjectivity that accounting standards were developed.
2. The realization concept: Realization:  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.
3. Duality:  Every transaction has two-fold effect in the accounts and is the basis of double entry bookkeeping.
4. 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.

Example 3.1

It is generally agreed that sales revenue should only be ‘realized’ and so ‘recognized’ in the trading, profit and loss account when:

1. The sale transaction is for a specific quantity of goods at a known price, so that the sales value of the transaction is known for certain.
2. The sale transaction has been completed, or else it is certain that it will be completed (e.g. in the case of long-term contract work, when the job is well under way but not yet completed by the end of an accounting period).
3. The critical event in the sale transaction has occurred.  The critical event is the event after which: 

1. It becomes virtually certain that cash will eventually be received from the customer.
2. Cash is actually received.

Usually, revenue is ‘recognized’

1. When a cash sale is made.
2. The customer promises to pay on or before a specified future date, and the debt is legally enforceable.

The prudence concept is applied here in the sense that revenue should not be anticipated, and included in the trading, profit and loss account, before it is reasonably certain to ‘happen’.

Required

Given that prudence is the main consideration, discuss under what circumstances, if any, revenue might be recognized at the following stages of a sale.

(a) Goods have been acquired by the business, which it confidently expects to resell very quickly.
(b) A customer places a firm order for goods.
(c) Goods are delivered to the customer.
(d) The customer is invoiced for goods.
(e) The customer pays for the goods.

(f) The customer’s cheque in payment for the goods has been cleared by the bank.

Answer

1. A sale must never be recognized before a customer has even ordered the goods.  There is no certainty about the value of the sale, nor when it will take place, even if it is virtually certain that goods will be sold.
2. A sale must never be recognized when the customer places an order.  Even though the order will be for a specific quantity of goods at a specific price, it is not yet certain that the sale transaction will go through.  The customer may cancel an order; the supplier might be unable to deliver the goods as ordered or it may be decided that the customer is not a good credit risk.
3. A sale will be recognized when delivery of the goods is made only when:

1. The sale is for cash, and so the cash is received at the same time.
2. The sale is on credit and the customer accepts delivery (e.g. by signing a delivery note).

1. The critical event for a credit sale is usually the dispatch of an invoice to the customer.  There is then a legally enforceable debt payable on specified terms, for a completed sale transaction.
2. The critical event for a cash sale is when delivery takes place and when cash is received, both take place at the same time. It would be too cautious or ‘prudent’ to await cash payment for a credit sale transaction before recognizing the sale, unless the customer is a high credit risk and there is a serious doubt about his ability or intention to pay.
3. It would again be over-cautious to wait for clearance of the customer’s cheques before recognizing sales revenue. Such a precaution would only be justified in cases where there is a very high risk of the bank refusing to honour the cheque.

1. 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 Noncurrent Assets (e.g. by straight line or reducing balance method)
• Treatment and amortization of intangible assets (patents and trademarks)
• Stocks and work in progress (FIFO, LIFO and AVCO)

1. 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.

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