Accounting Concepts and Conventions
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
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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.
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Separate Entity
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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.
Evaluation on Companies Social Accounting |
Realisation
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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.
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Materiality
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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.
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Accounting Concepts
Four important accounting concepts underpin the preparation of any set of accounts:
Going Concern
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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.
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Consistency
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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.
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Prudence
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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.
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Matching (or "Accruals")
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Income should be properly "matched" with the expenses
of a given accounting period.
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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
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Understandability
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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
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Relevance
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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?)
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Consistency
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This implies consistent treatment of similar items and
application of accounting policies
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Comparability
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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.
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Reliability
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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).
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Objectivity
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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
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