Accounting Concepts
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Accounting Concepts and Conventions
In drawing up accounting statements, whether they are external "financial accounts" or internally-focused
"management accounts", a clear objective has to be that the accounts fairly reflect the true "substance" of
the business and the results of its operation.
The theory of accounting has, therefore, developed the concept of a "true and fair view". The true and fair
view is applied in ensuring and assessing whether accounts do indeed portray accurately the business'
activities.
To support the application of the "true and fair view", accounting has adopted certain concepts and conventions
which help to ensure that accounting information is presented accurately and consistently.
Accounting Conventions
The most commonly encountered convention is the "historical cost convention". This requires transactions
to be recorded at the price ruling at the time, and for assets to be valued at their original cost.
Under the "historical cost convention", therefore, no account is taken of changing prices in the economy.
The other conventions you will encounter in a set of accounts can be summarised as follows:
- Monetary measurement
Accountants do not account for items unless they can be quantified in monetary terms. Items that are not
accounted for (unless someone is prepared to pay something for them) include things like workforce skill,
morale, market leadership, brand recognition, quality of management etc.
- Separate Entity
This convention seeks to ensure that private transactions and matters relating to the owners of a business
are segregated from transactions that relate to the business.
- Realisation
With this convention, accounts recognise transactions (and any profits arising from them) at the point of sale
or transfer of legal ownership - rather than just when cash actually changes hands. For example, a company
that makes a sale to a customer can recognise that sale when the transaction is legal - at the point of contract.
The actual payment due from the customer may not arise until several weeks (or months) later - if the
customer has been granted some credit terms.
- Materiality
An important convention. As we can see from the application of accounting standards and
accounting policies, the preparation of accounts involves a high degree of judgement. Where decisions are
required about the appropriateness of a particular accounting judgement, the "materiality" convention suggests
that this should only be an issue if the judgement is "significant" or "material" to a user of the accounts. The
concept of "materiality" is an important issue for auditors of financial accounts.
Accounting Concepts
Four important accounting concepts underpin the preparation of any set of accounts:
- Going Concern
Accountants assume, unless there is evidence to the contrary, that a company is not going
broke. This has important implications for the valuation of assets and liabilities.
- Consistency
Transactions and valuation methods are treated the same way from year to year, or period
to period. Users of accounts can, therefore, make more meaningful comparisons of financial performance
from year to year. Where accounting policies are changed, companies are required to disclose this fact and
explain the impact of any change.
- Prudence
Profits are not recognised until a sale has been completed. In addition, a cautious view is
taken for future problems and costs of the business (the are "provided for" in the accounts" as soon as their
is a reasonable chance that such costs will be incurred in the future.
- Matching (or "Accruals")
Income should be properly "matched" with the expenses of a given accounting period.
Key Characteristics of Accounting Information
There is general agreement that, before it can be regarded as useful in satisfying the needs of various user
groups, accounting information should satisfy the following criteria:
- Criteria
What it means for the preparation of accounting information
- Understandability
This implies the expression, with clarity, of accounting information in such a way
that it will be understandable to users - who are generally assumed to have a reasonable knowledge of
business and economic activities
- Relevance
This implies that, to be useful, accounting information must assist a user to form, confirm
or maybe revise a view - usually in the context of making a decision (e.g. should I invest, should I lend money
to this business? Should I work for this business?)
- Consistency
This implies consistent treatment of similar items and application of accounting policies
- Comparability
This implies the ability for users to be able to compare similar companies in the same industry
group and to make comparisons of performance over time. Much of the work that goes into setting accounting
standards is based around the need for comparability.
- Reliability
This implies that the accounting information that is presented is truthful, accurate, complete
(nothing significant missed out) and capable of being verified (e.g. by a potential investor).
- Objectivity
This implies that accounting information is prepared and reported in a "neutral" way. In other
words, it is not biased towards a particular user group or vested interest
