The Concepts and Conventions of Accounting
Accounting concepts and conventions as used in accountancy are the rules and guidelines by which the accountant lives. All formal accounting statements should be created, preserved and presented according to the concepts and conventions that follow.
Let's look at the main concepts in turn now
This concept is the underlying assumption that any accountant makes when he prepares a set of financial reports. That the business under consideration will remain in existence for the foreseeable future. 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: we call it a fire sale these days. 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. In addition, who wants what you are selling if you are already in trouble?
The purpose of this concept is to make sure that all revenues and costs are recorded in the appropriate statement at the appropriate time. So, 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 used 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'. So, 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. So, 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.
Here is 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!
Here are two examples of materiality in action:
Sales (£'000) 125,000
Sales (£ million) 125
Get the point?
The realisation concept helps the accountant to determine the point at which 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 and Fair Value accounting is with us now!
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 to explore some of these issues in more detail.