Author: Jim Riley Last updated: Sunday 23 September, 2012
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
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.
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:
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
like workforce skill, morale, market leadership, brand recognition,
quality of management etc.
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.
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.
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.
Four important accounting concepts underpin the preparation
of any set of accounts:
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.
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.
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.
Matching (or "Accruals")
Income should be properly "matched" with the expenses
of a given accounting period.
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:
What it means for the preparation of accounting
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
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?)
This implies consistent treatment of similar
items and application of accounting policies
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.
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).
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