Accounting concepts and conventions
There are certain rules and procedures that we follow when we draw up accounts. These are rules that are not stated visibly, but are there to guide us in deciding whether something is or is not allowed. Accounting concepts and conventions are the guidelines that we should follow when drawing up our accounts. These are there to guide us in time when we have a number of alternative options available.
Some of the concepts are stated in Accounting standards - which are the actual formal guidelines (these are not legal requirements - but nearly all companies will follow the standards, this is explored in 6.4) governing how accounts are to be drawn. However, some of these concepts are just simple guidelines which are there to assist us when making decisions. The accounting concepts and conventions are as follows:
To be prudent in accounting is to be cautious. This means that we should be cautious when valuing assets or when measuring profits, possibly attempting to be pessimistic if we have a choice. Examples of prudence would include the following:
- Depreciation of fixed assets (3.1.4)
- Valuing stocks at cost or net realisable value (selling price minus any costs involved in getting stock into saleable condition) whichever of these two is lowest
- Creating provisions for doubtful debts (3.1.3)
- Creating provisions for unrealised profits on unsold stock (3.3.2)
It would also include not anticipating profits before they are actually earned - only counting a sale when the order is actually received. If possible we should recognise that expenses have occurred as quickly as possible, but we should be less quick to recognise income. Prudence is sometimes known as conservatism and is generally one of the most common concepts that you will come across.
The profit and loss account of any firm should show the expenses or the revenues relating to the period in which they were incurred or generated rather than the period in which cash is paid or received. This system is known as the accruals concept (it is sometimes also known as the matching concept). This means that the profit figure for a firm may not be that closely connected with actual amounts of money paid or received. It also means that we will have to deal with accruals and prepayments in the ledger accounts - where payments made do not belong to the current accounting period.
This concept links with prudence but is specifically focused on deciding when profit has been generated. One of the main elements of this concept is in deciding when a sale has been made. There are various stages when a sale could have been made, these are:
- When the goods have been produced
- When a buyer has agreed to purchase goods
- When the goods have been delivered
- When payment has been received from the customer
The realisation concept states that a sale should only be recognised when we can be reasonably certain that we will receive money connected with the sale. This usually occurs when an order is made by the customer. Of course, we still may not sell these goods - the customer may cancel or return goods - but we can be reasonably certain that the firm has made a sale and therefore will receive money in the future.
This concept makes the assumption that the business will continue trading into the future. With this assumption made, any attempt to value assets at their current market value (rather than their original cost) would not be sensible - why value an asset at its current selling price when we are not expecting to sell it?
The value of fixed assets should therefore be their historical cost (original cost). This value can be verified and is therefore more objective than any estimates or other subjective personal valuations.
It is allowable to value stock at less than its original cost if the net realisable value is expected to be lower than the historical cost. Also, fixed assets (especially land and propriety) can be revalued (upwards) if the historical cost is significantly out of step with current market valuations. Any revaluation should only be undertaken on an infrequent basis.
This concept aims to ensure that business stick with the same techniques over a long period of time. In accounting, there are some choices that have to be made when, for instance, deciding on how to depreciate fixed assets. Even if the method chosen is not ideal, it is important that a firm sticks with the method chosen. This is an illustration of the concept of consistency. By sticking with the same methods for depreciation, and for valuation of stocks, a firm can ensure that comparisons between earlier and future period of time can be made with some credibility. If methods are changed frequently, then profits and other data may not be as easily compared with other periods of time. In fact some firms may deliberately change methods to try to boost profits.
This does not mean that no change in methods is allowed, but simply that changing methods should be avoided if possible. Any changes to methods should only take place on an infrequent basis, provided that sound reasons for the change are disclosed in the final accounts.
For sole traders and partnerships, there is no distinction made in the legal system between the owner of the firm and the firm itself. This mans that if the either of these forms of organisation are forced to close and have debts to clear, the owner(s) can me made to sell personal possessions to clear those debts.
However, as far as recording accounting transactions goes, all private transactions should be kept separate and not recorded in the firm's accounts. The only dealing with the owner's finances will be in the form of either drawings (when the owner withdraws resources) or capital (when resources are put into the firm by the owner). This idea is known as the business entity (or separate entity) concept.
The distinction between what constitutes an asset or an expense is not always easy to make. For some firms, purchases of new furniture may represent a large item of expenditure, but for large firms, the expenditure may be fairly trivial compared with overall expenses. This means some firms may treat some items that are classified as capital expenditure (i.e. assets) as revenue expenditure instead (i.e. expenses). Similarly, if a firm purchases, say, some stationery, and finds that it has some of this left over at the end of the year, it is highly unlikely that the firm would want to record this unused stationery as stocks (or any other type of asset). This is because the amounts of money that we would be dealing with are probably small compared with other items in the firm's accounts.
The concept of materiality is concerned with making sure that amounts, which are insignificant in size, do not get recorded in the accounts as assets when they could be recorded simply as an expense. The phrase 'writing off as an expense' will be used by firms who feel that recording something as an asset would not be necessary as far as trying to show a true and fair view of the firm is concerned.
What is counted a material and what is to counted as material will, of course depend on the size of the firm
- Item is material - Show as an asset
- Item is not material - Write off to profit and loss as expense
Anything in the accounting system that is based on factual events is said to be objective. For example, use of historical costs (original cost) for asset valuations is based on objective and verifiable evidence (it actually has happened).
Any attempt to use personal opinion is said to be subjective. If we allow subjectivity to influence our accounts then these may become biased and not reflect the true and fair view of the business. There is also the danger that firms may also deliberately bias the accounts in a way which misleads, say, potential investors.
We do allow some subjectivity. For example, estimates of the provisions for doubtful debts and depreciation involve our own estimates.
Conflicts with the concepts
Sometimes you will find that concepts seem to contradict each other. In this case, one of the concepts will have to be seen to overrule another. Common examples of conflict, and how these are resolved are as follows:
Stocks should always be valued at the lowest of cost or net realisable value. Net realisable value is the selling price of the stock minus any costs involved in getting this stock into saleable condition (e.g. repair costs). This means that we can value stock at current market rates, but only if the selling price is lower than the cost.
However, if the replacement cost of these stocks is lower than cost or net realisable value then it may seem prudent to use the replacement cost to value these stocks. This is not allowed in the UK.
Fixed assets should be valued at their historical cost (because it is objective). However, it is prudent to reduce their values to reflect wear and tear. Also, according to the accruals concept, we should match an expense to when it was incurred. Therefore, fixed assets appear as their historical cost less any depreciation. Also, the cost of these assets will be 'spread' over their lifetime in the accounts.
- The concepts are likely to be tested in the context of a business scenario.
- You must refer to the concept(s) when giving advice
- The most commonly tested concepts are prudence, accruals and consistency
These notes are aimed at people studying for AQA A Level Accounting Unit 3, but will also be suitable for other courses and exam boards.
Originally submitted by duke_stix on TSR Forums.