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Thursday, July 12, 2012

Explain and provide examples to illustrate the following accounting concepts.a)Accrualb)Prudencec)Going concernd)Historical Cost

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Financial statements, profit and loss accounts, balance sheets, cash flow statements etc, are produced on an annual basis to report to parties outside of organisation on its financial performance, financial position, and its cash flow over the period. Although the double entry system is a mechanical operation, accounting is sometimes subjective. Preparing financial statements is not absolutely automatic. Their content and layout are influenced by company law, accounting standards and accounting concepts. Accounting concepts are the fundamental principles and rules which the qualified accountants are supposed to follow when preparing financial statements. They can be used to build up an accounting framework. Some authors refer to them under a variety of other names, such as basic rules, assumptions, axioms, conventions, postulates, principles, or procedures.

There is no definitive list of fundamental accounting concepts. Different writers give different sets of concepts. FRS 18 (Financial Reporting Standard) Accounting Policies identifies two prominent concepts going concern and accruals (issued in December 000). The Companies Act 185 describes five concepts as fundamental going concern, accruals, prudence, consistency and the separate valuation principle. SSAP (Statements of Standard Accounting Practice) lists four fundamental accounting concepts as follows going concern, accruals, consistency and prudence (issued in November 171). And there are five underlying accounting concepts as follows the historical cost concept, the money measurement concept, the business entity concept, the dual aspect concept and the time interval concept.

Next step we will single out the following four concepts for further discussion

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a) The accruals concept

b) The prudence concept

c) The going concern concept

d) The historical cost

a) The accruals concept

The accruals concept is also called matching concept. “The accruals concept dictates when transactions with third parties should be recognised and, in particular, determines the accounting periods in which they should be incorporated into the financial statements.”(4) That means when accountants prepare the profit and loss account, the revenues and costs should be considered accrued even though the money is not received or paid. The timing normally coincides with the delivery of goods or the performance of services, not the payment or receipt of cash.

The accruals concept can be illustrated in the example as following ABC plc bought a motor vehicle on credit for £16,000 on 8 April and received it on 15 April. ABC plc bought three computers for cash £,500 on 1 April, and they would deliver in three weeks time. ABC plc sold goods on credit for £1,50 on 7 April.

In the end of April, when the accountants prepared the financial statements, £16,000 should be recorded as a purchase. ABC plc had not paid the money yet, however, they have got the motor vehicle already. That means the transaction had occurred, therefore, under the accruals concept, it should be recorded. ABC had already paid for the computers; however, they had not got them in the end of this accounting period. Hence, this transaction should be deal with advanced payment under the creditor within twelve months. Although ABC plc had not received the money from customer; however, the goods had already transfer to the customer. Therefore accountants should record this sale £1,50 into revenue.

Accruals concept is the key rule for accounting for profit.



b) The prudence concept

“The prudence concept (sometimes called ‘conservatism’) means that accounts include revenues (and profits) only when they are ‘realised’.” (5) It introduces caution into the recognition of assets and revenues for financial reporting purposes. Accountants very often have to use their judgment to decide which figure they should take into the financial statements. The easy way to remember is that the income should not be recorded until it is realised, but unrealised losses should be recognised immediately. Suppose the sales people recognised the order as sales. However, under the prudence concept, the accountant considers only that the goods have already transferred to the customer and the buyer accepts liability to pay for them is sales. That means profit can only be taken into account when realisation has occurred.

The accountant is prudent in ascertaining profit.

c) The going concern concept

“The going concern concept assumes that the business enterprise will continue in operational existence for the foreseeable future. This assumption introduces a constraint on the prudence concept by allowing the account balance to be reported on a depreciated cost basis rather than on a net realizable value basis.”(6) That means that the accountant values assets at cost less depreciation or net book value, on the assumption that they are worth at least this much.

Depreciation is a good example for the using of the going concern concept. Fixed assets such as machinery, motor vans, fixtures and even building do not last for ever. Therefore, a depreciation charge will be deducted from the cost of buying them. Suppose, a company bought a machine for £100,000 and the company will continue the operations, hence, this machine as asset will live out its full twenty years in use. We can calculate that the depreciation is £5,000 each year (£100,000 / 0). Therefore, the value of this machine in the balance sheet should be the cost of this machine minus the depreciation. The value will be £5,000 in the end of the first year and £0,000 in the end of the second year. After twenty years, the value will be 0.

The going concern concept is very important for valuing the fixed assets, because when the business close down, valuing these assets is very different. However, if the business is going to close down in the near future, the going concern concept should not be made.

d) The historical concept

The historical cost means assets are recorded at the original cost price to value in the balance sheet, rather than current value. Under this concept, transactions are reported at the £ amount recorded at the date the transactions occurred. Under the historical cost concept, therefore, no account is taken of changing prices in the economy. The greatest advantage of this concept is under it, the value of assets or the expenses are stated objectively.

Normally, when accountants prepare the financial reports, inflation will be ignored and the stability of currency will be assumed. They prefer to adopt the original cost of the asset.

For instance, a company bought a motor vehicle for £16,000. After two years, on the secondhand market, it is only worth £10,000. If the company buys a same new motor vehicle, it costs £1,000 because of the inflation. However, the accountant use the original cost £16,000 which occurred when the company bought the motor van. Neither £10,000 nor £1,000 will be adopted.

In conclusion, in preparing and presenting information, accountants have considerable freedom over which rules to adopt and how they should be interpreted. If accountants are subjective, it means that they use their own method, even though no one else may agree to it. The financial statements which accountants prepare must be disordered and immeasurable. 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. Accountants must avoid being subjective. The desire to provide the same set of accounts for many different parties, and thus to provide a measure that gains their consensus of option, means that objectivity is sought in financial accounting. 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 businesss activities. That set of concepts must be objective that means all can agree to, instead of everyone using their own different method. Accounting concepts which support the application of the true and fair view are very important for helping to ensure that accounting information is presented accurately and consistently.

Question

(4) Page

Financial Accounting and Reporting (5th Edition)

Page 4

By Barry Elliott & Jamie Elliott, 001

Prentice Hall

(5) Page 10

Accounting and Financial Decisions (New Edition)

Page 7

By D. R. Myddelton, 11

Longman Singapore Publishers Pte Ltd.

(6) Page 10 - 11

Financial Accounting and Reporting (5th Edition)

Page 1

By Barry Elliott & Jamie Elliott, 001

Prentice Hall

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