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Accounting Concepts and Conventions

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 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

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.

Separate Entity

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.

Realisation

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.

Materiality 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.

Accounting Concepts

Four important accounting concepts underpin the preparation of any set of accounts:

Going Concern 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.
Consistency 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.
Prudence 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:

Criteria What it means for the preparation of accounting information
Understandability 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
Relevance 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?)
Consistency This implies consistent treatment of similar items and application of accounting policies
Comparability 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.
Reliability 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).
Objectivity 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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Related study notes

INTRODUCTION TO ACCOUNTS
Introduction to Accounting
Users of Accounts
Accounting Concepts and Conventions
Stakeholder Theory
Characteristics of Accounting Information
Alternatives to Profit Maximisation
Maximising the Value of a Business
Non-financial Objectives of a Business
Comparison of Financial and Management Accounting

BUDGETING
Financial objectives - intro
Financial objectives - key measures
Introduction to Business Planning
Introduction to Budgets
Purpose and Role of Budgets
Incremental Budgeting
Zero-based Budgeting
Variance analysis
Budgeting limitations

COMPANY FORMATION
Introduction to Business Organisation
Forming a Company
Advantages of Incorporation

FINANCIAL MANAGEMENT
Introduction to Financial Management
Introduction to Working Capital
Working Capital Needs of Different Businesses
Working Capital Cycle

SOURCES OF FINANCE
Managing Business Cash Flows - An Introduction
Introduction to Raising Business Finance
Sources of Finance for SMEs
Overdraft Financing
Business Angels
Introduction to Venture Capital
Sources of Equity Finance
Rights Issues
New Share Issues & Flotations
Intoduction to Leasing
Leasing - Advantages & Disadvantages

FINANCIAL STATEMENTS
Introduction to Financial Accounting
Income Statement
Profit quality
Balance Sheet
Current assets
Current liabilities

RATIO ANALYSIS
Introduction to Ratio Analysis
Interpreting Financial Information
Accounts & financial performance
ROCE
Asset turnover
Stock turnover
Debtor days
Creditor days
Liquidity ratios
Gearing ratio
Shareholder ratios
Limitations of ratios

ACCOUNTING ISSUES
Accounting for Fixed Assets - Introduction
Depreciation
Depreciation - Straightline Method
Depreciation - Reducing Balance Method

STAKEHOLDERS
Stakeholders - intro
Stakeholder power
Stakeholder conflicts

 


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