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Accounting concepts and conventions as
used in accountancy are the rules and guidelines by that the accountant
lives. All formal accounting
statements should be created, preserved and presented according to the concepts
and conventions that follow.
In the United Kingdom, four of the following accounting
concepts are laid down in Statement of Standard Accounting Practice number 2
(SSAP 2: Disclosure of Accounting Policies), they are the
This concept is
the underlying assumption that any accountant makes when he prepares a set of
accounts. That the business under
consideration will remain in existence for the foreseeable future. In addition to being an old concept of
accounting, it is now, for example, part of UK statute law: reference to it can
be found in the Companies Act 1985.
Without this concept, accounts would have to be drawn up on the 'winding
up' basis. That is, on what the business is likely to be worth if it is sold
piecemeal at the date of the accounts.
The winding up value would almost certainly be different from the going
concern value shown. Such
circumstances as the state of the market and the availability of finance are
important considerations here.
Otherwise known
as the matching principle. The purpose
of this concept is to make sure that all revenues and costs are recorded in the
appropriate statement at the appropriate time. Thus, when a profit statement is compiled, the cost of goods
sold relevant to those sales should be recorded accurately and in full in that
statement. Costs concerning a future
period must be carried forward as a prepayment for that period and not charged
in the current profit statement. For
example, payments made in advance such as the prepayment of rent would be treated
in this way. Similarly, expenses paid
in arrears must, although paid after the period to that they relate, also be
shown in the current period's profit statement: by means of an accruals
adjustment.
Because the
methods employed in treating certain items within the accounting records may be
varied from time to time, the concept of consistency has come to be applied
more and more rigidly. For example,
because there can be no single rate of depreciation chargeable on all fixed
assets, every business has potentially a lot of discretion over the precise
rate it chooses to use. However, if it
wishes, a business may vary the rates at which it charges depreciation and
alter the profits it reports at the same time. Consider the effects on profit of charging depreciation at 15%
this year on £10,000 worth of fixed assets and then charging depreciation at
10% next year on the same £10,000 worth of fixed assets. This year you would charge £1,500 against
profits and next year it would be only £1,000, using the straight line method
of providing for depreciation.
Because of these sorts of effects, it is now accepted
practice that when a company chooses to treat items such as depreciation in a
particular way in the accounts it should go on using that method year after
year. If it is NECESSARY to change the
method being employed or the rates being charged then an explanation of the
change and the effects it is having on the results must be shown as a note to
the accounts being presented.
Otherwise known
as conservatism. It is this concept
more than any other that has given rise to the idea that accountants are pessimistic
boring people!! Basically the concept
says that whenever there are alternative procedures or values, the accountant
will choose the one that results in a lower profit, a lower asset value and a
higher liability value. The concept is
summarised by the well known phrase 'anticipate no profit and provide for all
possible losses'. Thus, undue optimism
can never be part of the make up of an accountant! The danger is that if an optimistic view of profits is given
then dividends may be paid out of profits that have not been earned.
The objectivity
concept requires an accountant to draw up any accounts, and further analysis,
only on the basis of objective and factual information. Thus, this concept attempts to ensure that
if, for example, 100 accountants were to draw up a set of accounts for one
business, there would be 100 identical accounting
statements prepared. Everyone would be
obtaining and using only facts. The problem
here is that there are many aspects of accounting ensuring that objectivity cannot be universally applicable in the
preparation of accounts. For example,
with fixed assets: the cost of a van must be known at its purchase: say
£30,000. However, how long will this
van be in service? I say five years,
my colleague could say 10 years. If I
prepare the accounts using the straight line method of depreciation
calculation, I would provide £30,000 ÷ 5 = £6,000 each year for depreciation;
my colleague would charge £30,000 ÷ 10 = £3,000 each year for depreciation; and
both of us could be correct! The
problem is that with an issue such as depreciation we are not always able to be
objective.
This is the very
foundation of the universally applicable double entry book keeping system and
it stems from the fact that every transaction has a double (or dual) effect on
the position of a business as recorded in the accounts. For example, when an asset is bought,
another asset cash (or bank) is also and simultaneously decreased OR a
liability such as creditors is also and simultaneously increased. Similarly, when a sale is made the asset of
stock is reduced as goods leave the business and the asset of cash is increased
(or the asset of debtors is increased) as cash comes into the business (or a
promise to pay is made and accepted).
Every financial transaction behaves in this dual way.
Otherwise known
as the 'accounting entity' concept.
The idea here is that the financial transactions of one individual or a
group of individuals must be kept separate from any unrelated financial
transactions of those same individuals or group. The best example here concerns that of the sole trader or one
man business: in this situation you
may have the sole trader taking money by way of 'drawings': money for his own
personal use. Despite it being his
business and apparently his money, there are still two aspects to the
transaction: the business is 'giving' money and the individual is 'receiving'
money. So, the affairs of the
individuals behind a business must be kept separate from the affairs of the
business itself.
This concept is
based on the notion that only the costs paid to acquire an asset are relevant
and thus should be the only costs to be shown in the accounts. For example, fixed assets are shown on the
balance sheet at the price paid to acquire them; that is, their historic cost
less depreciation written off to date.
There is a problem in this area. That is the one of value.
The accountant will rarely talk of value in this context since the use
of such a term implies personal bias.
After all, the value of an asset as far as I am concerned may be
different to the value of the same asset as far as you may be concerned. The application of the cost concept ensures
that subjective judgements play no part in the drawing up of accounting
statements.
The money measurement concept is one of
the simpler concepts. It simply and clearly
states that only those transactions that are true financial transactions may be
accounted for. That is, only those
transactions that may be expressed in money values (whatever the currency) are
of interest to the accountant.
We are concerned
here with the idea that accountants should concern themselves only with matters
that are significant because of their size and should not consider trivial
matters. The problem, of course, is in
deciding what is and what is not material: we are concerned here with RELATIVE
IMPORTANCE. As far as an individual is
concerned, the loss of a £10 would be important and MATERIAL. As far as Chevron or Barclays Bank are
concerned, the loss of £10 could be considered unimportant in many
circumstances and therefore immaterial: please note I am not suggesting that
fraud or carelessness in the handling of money is acceptable!!
The realisation
concept helps the accountant to determine the point at that he feels that a
transaction is certain enough for the profit to be made on it to be calculated
and taken to the profit and loss account.
Realisation occurs when a sale is made to a customer. The basic rule is that revenue is created
at the moment a sale is made, and not when the account is later settled by
cheque or by cash. Thus, profit can be
taken to the profit and loss account on sales made, even though the money has
not been collected. The sale is deemed
to be made when the goods are delivered, and thus profit cannot be taken to the
profit and loss account on orders received and not yet filled. An exception to this rule would be a long
term contract that involve payments on account before completion of the work.
Normal or
historic cost accounting assumes that transactions occurring over a period of
time can be measured in terms of a single, stable measuring unit eg Pounds,
Dollars ... This means that, in the UK, all accounts are drawn up in Pounds;
and this year's balance sheet can be compared with last year's balance
sheet. Consequently, if fixed assets brought
down from last year were £1,000 and a further £500 of fixed assets were bought
during this year, we would say fixed assets carried down from this year were
worth £1,000 + 500 = £1,500. All of
this gives rise to consistency but there is a problem with reality inflation
means that very few currencies are truly stable.
Many attempts have been made at solving this problem,
incidentally, but, in the UK, for example, all efforts have proven
useless. The only really meaningful
accounting directive ever enacted on this subject was withdrawn by the
accounting bodies in the UK several years ago.
These,
then, are the basic concepts and conventions on which the accountant bases all
of his accounting work. We can see evidence
of such work in the published annual reports and accounts that all publicly
quoted companies are required to prepare and publish. The concepts and conventions also apply to the millions of
businesses world wide that do not publish their accounts.
When we look at the work of an accountant we can see
evidence that he has followed these concepts and conventions: we will see
accrued expenses, we will see that there is a statement to the effect that the
accounts have been drawn up on the basis of the going concern concept … and so
on.
There are problems with these concepts and conventions,
however, in that some of them conflict with each other. For example, money measurement and
materiality can conflict, consistency and materiality can conflict. Have a look at the next page Conflicts
in accounting concepts
© Duncan
Williamson
June 1999
