Accounting Concepts

Why are accounting concepts needed?

The accounts of a business should reflect a true and fair value of its
financial position. To achieve this, accountants apply a series of rules or
ACCOUNTING CONCEPTS
By using agreed concepts when analysing and presenting financial data, accountants can avoid
confusion and inconsistency, and there is less scope for presenting misleading information. Also,
the accounts of different companies can be compared more easily.
There are several accounting concepts we must consider:
ACCRUALS/MATCHING concept (see other handout)
Revenue should be recognised when it is earned, not when it is received. This means, if we sell
goods on credit in December, but dont receive payment until February. We should record the sale
as revenue in December.
The same principle applies to costs incurred by the business. Costs should be recognised when
they are incurred, not when the money is actually paid.
GOING CONCERN CONCEPT (also known as the Historical Cost Concept)
This assumes that a business will carry on trading for the foreseeable future, and is
not expected to close down or be sold. This is important when valuing a firms
assets. If the firm is a going concern then the assets can be valued at their historical cost (the price
originally paid). However, if the firm was to be closed down, then assets should be valued at their
break-up value. This is the value they would receive if they sold the assets, so really a second
hand price. This would probably be lower then the historical cost, apart from property or land
which could well be worth more.
Inflation can create problems. It is a general and persistent rise in prices. Because it causes land
and property prices to rise, the historical cost of these assets is likely to be less then their current
value. For this reason, business sometimes arrange for a professional revaluation of these assets in
order to reflect a true and fair view of what they are worth.
Exam tip: Often questions describe a scenario such as Joe Bloggs has owned a building for many
years, and its historical cost is 100,000. His friend (who might even be an estate agent) reckons
it is worth loads more, and thinks he could sell it for 200,000.
How should we value the building?
Answer: 100,000. This is the Historical Cost. This also links to the Objectivity concept which
tells us to stick to the facts (i.e. the purchase price actually paid) and not go with somebodys
opinion which is highly subjective.
However, Joe Bloggs could have a professional revaluation of his building, done by an Estate
Agent who could actually try and sell it for him. He can now value the building at whatever the
Estate Agent says following the professional revaluation.

Miss Hunter - Accounting Concepts

Complete question 2 on page 51 of Jones

CONSISTENCY concept
This states the accounts of a business should be prepared on the same basis
every year, so there should be consistent treatment of similar items within
each accounting period, from one period to the next. This allows accounts to
be compared from one period to the next. If we did not have consistent
policies it would be unclear if the changes in reported profits or value of
assets was due to changes in business conditions or accounting practice of
the business.
Example: We have two choices when decided how to calculate Depreciation
(more later in this module).
1.) Straight Line Method (Creates larger profits in the short run, but smaller in the long run).
This is most appropriate for an Asset like Buildings, Property or Land.
2.) Reducing Balance Method (Creates smaller profits in the short run, but larger in the long
run). This method is most appropriate for an Asset like Vehicles, or Computers.
However, BOTH methods will EVEN OUT over time.
A business can choose either method, but should choose the method that is most appropriate to
that particular Asset. A business should therefore be Consistent and not chop and change from
one method to the other from year to year.
Can the business ever change its policy?
A business can change accounting policies, and if so they must declare this in the final accounts.
Sometimes a business may do this deliberately to convey a false impression, this is known as
window dressing.
PRUDENCE concept
This states that accountants should be cautious when reporting the financial position of a business.
It is better to understate profits or the value of assets than to overstate them. Accountants should
generally:

Not record revenue or profit until it is certain or realised.

Choose the lowest value, when valuing assets, e.g. debtors.
Anticipate all possible losses and record them as soon as they are known.
Choose the highest value when faced with different estimates of costs.

Choose the lowest value when faced with a choice when valuing stock.
I.e. Net realisable value (selling price less any costs incurred in getting goods
into a saleable condition) or historical cost this ensures profits are not over stated.

Miss Hunter - Accounting Concepts

Conflict with the Going Concern/Historical Cost Concept

We can also find difficulties when valuing stock. The prudence concept states that stock should be
valued at the lower of net realisable value or historical cost. Therefore, it states that if stock can
only be sold cheaply (perhaps because it is out of fashion, or out of date), it is the net realisable
value that should be used, not the historical cost.
The Historical Cost concept would say the opposite. In this case the Prudence Concept will
overrule the Going Concern/Historical Cost concept.
What is so bad with overstating profits?
If we did overstate profits, then resources could be depleted by excessive drawings or dividends,
which might jeopardise the future of the business.
An example would be if a business purchased a vehicle at auction for 1000 and then discovered it
was actually worth 2000, it should list the lower value in the balance sheet. This is a cautious or
conservative valuation.
Also, if a firm sold goods on credit and then the customer went bankrupt, the business should
immediately record this as a bad debt, which is an expense on the profit and loss account.
MATERIALITY concept
This says that accountants should not waste time trying to record items that
are trivial or immaterial. Items are only considered material if their
omission from the final accounts is misleading. This could be for
classifying expenses. Often we use headings such as insurance or heating
and lighting. However, in the case of inexpensive items a heading of
sundry expenses is used.
Also this concepts applies when categorising capital and revenue
expenditure. A purchase of waste paper bin, which would be used
repeatedly over a period of time, is technically capital expenditure as it is
a fixed asset and should be included in the balance sheet. However, because it is rather trivial, and
immaterial, we are allowed to class this as revenue expenditure, and it would therefore be an
expense on the profit and loss account. This avoids cluttering the balance sheet with trivial items.
Unfortunately, the concept does not provide clear guidelines to help a business decide which
transactions are material. They may decide to treat all capital expenditure under 50 as revenue
expenditure. However, a larger firm may use 500 as the limit.
Complete Question 3 on page 52 of Jones

Miss Hunter - Accounting Concepts

REALISATION concept
This states that revenue should not be recognised until the exchange of
goods or services has taken place, or in other words, until it has been
realised. This could be when goods are sold on a sale or return basis.
Only when a business knows that goods sold are not going to be returned
should it record the sales revenue.
For example. A Newspaper Shop received its papers (which are all on sale
or return) from all the different suppliers (e.g. The Times) each morning.
The Times will not recognise these as sales until the end of the day when they are certain that no
goods will be returned. Only then will they be sure that the revenue has been realised.
Business entity concept
This states that the financial affairs of a business should be completely separate from the owner.
The business is a separate entity. Therefore, personal transactions should not be confused with
business transactions. Difficulties arise when, for example, a van is used all week for a business,
but used at the weekend by the owner for personal use. The costs must then be divided between the
business and the owner.
Legally, a sole trader and partnership have no separate entity from the owner, as the owner has
unlimited liability and is responsible for the businesses debts, whereas a limited company has
limited liability, so the owner is not responsible for the debts of the business. However, for
accounting purposes we say that a business and its owner should always be treated as separate
entities.
Complete Question 1 on page 50 of Jones
Objectivity Concept
Accounts should be based on verifiable evidence,
rather than personal opinion. They should be objective rather than subjective. Therefore, if an
accountant was valuing the purchase of property, they should use the value on the invoice rather
than their own personal opinion. Obviously, everybody has different opinions so we must use the
invoice, and keep to the facts.
Conflicts between accounting concepts
There are occasions when the concepts conflict. Under these
circumstances, a choice has to be made as to which concept is most
important. For example, the going concern concept states that the
value of assets should be based on their historical cost. However, the
prudence concept states that the valuation should be based on the
lowest possible estimate.

Miss Hunter - Accounting Concepts

Now, this would probably be the true value if the company is about to close down, and is selling off
its assets, but lets presume the business is not closing down. Accountants would generally take the
view that the going concern concept is more important than the prudence concept.
So why is it important to apply the Accounting Concepts?

Accountants can avoid confusion and inconsistency, and there is less scope for presenting
misleading information.
They stop us from overstating profits, which prevents the resources being depleted by
excessive drawings or dividends, which might jeopardise the future of the business.
Helps to make comparisons between one year and the next (inter year comparisons).
Helps users of accounts (e.g. potential shareholders) to make comparisons between
different businesses easily. This helps them with any decisions they have to make (such as
deciding to invest or not).
Should make window dressing more difficult (i.e. it should prevent people changing the
calculation of depreciation each year which would distort the profits)

Complete Unit Assessment 1 & 2 on page 56 of Jones

Miss Hunter - Accounting Concepts