A discussion of fundamental accounting concepts

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Accounting concepts and conventions as used in accountancy are the rules and principles applied when recording economic events and in the preparation of financial statements, that all accountants abide by. Some of the fundamental accounting concepts that will be discussed are the accruals, prudence, going concern, business entity and consistency concepts.

In recording transactions, certain concepts and conventions have been agreed by the accountancy profession. Accounting statements should fairly reflect the true value of the business. Whether the accounting statements are for external or internal use, it has to be that the accounts reflect the true value of the business. To support this view, accountancy has adopted certain concepts and conventions which help to ensure that accounting information is presented accurately and consistently. Accounting concept and conventions [online], Date accessed 12/11/12.

Accruals concept is a principle followed by accountants that relates to matching costs with revenue. Under the accruals concept revenue and costs are accrued, matched with one another so far as their relationship can be established and accounted for in the same period of time in which the revenue is recognised. Thomas, A 1996

Having decided on the point at which revenue and expenses are recognised, we turn to the matching convention, which says that profits can only be recognised if sales are fully matched with costs accrued during the same period. Applying this convention may mean that a particular expense recorded in the profit and loss account for a period may not be the same figure as the cash paid for that item during the period. McLaney E, Atrill P 1999

All expenses should be matched to the period for which the sales revenue to which they relate is reported. In practice, this may be difficult to do for certain expenses such as gas charges, as this is unlikely to be linked directly to particular sales. Gas charges incurred would be matched to the period to which they relate. Let's say that the gas company has yet to send out bills for the quarter that ends on the same financial year end. In this situation, an estimate will have to be made of gas expense outstanding. If the gas expense is predicted reasonably accurately it will have the desired effect of showing that, on the end of year accounts and financial statements. Accountants often have to make estimates, which may be difficult to produce accurately especially if it's the first accounting year. All these estimates reflect on the true value of the business and the results of its operation.

When applying the concepts of accruals, some problems may arise for the business. Revenue and costs are accrued, matched together for the same time period in which the revenue is recognised. Revenue and costs are charged to the profit and loss account for the same accounting period in which they were accrued or incurred, not when money was received or paid. Therefore a false picture is displayed as to what the actual cash reserves available within the business; this could result in serious cash flow problems. The manager may think that the business is doing really well when the sales ledger may show many sales; while in reality the bank account may be empty because the debtors haven't paid or are late in settling their debts. Problems will arise when debtors haven't settled their debts or are late in doing so; this delay in payment would affect the working capital which could cause serious problems for the business. The profit indicated on the annual accounts is unrealistic, as this shows a false picture on the actual business performance at the end of the financial year.

Continuity (or going concern) this states that in the absence of evidence to the contrary it is assumed that the business will continue into the indefinite future. This concept has a major influence on the assumptions made when evaluating particular items in the balance sheet. This allows us to assume that stock will eventually be sold in the normal course of business (at normal selling prices) and for the principal of depreciation, If we assume a car will have a useful life to the business for five years, this fixed asset is depreciated over five years. Alexander D, Britton A 1999

Going concern concept is fundamental to the proper presentation of financial statements that absent such an assumption, financial statements can be rendered meaningless or misleading. The main significance is that the assets of the business should not be valued at their 'break-up value', which is the amount that they would sell for if the business was to liquidate. This gives the business a false picture as to how much the asset is worth. If the business was to liquidate, the immediate sell of value of the asset would be lower.

The prudence concept may be inconsistent with the matching principle which may cause problems for the business. Where a loss is foreseen, it should be anticipated and taken into account immediately, it is not right to wait until you recognise the loss; it must be recognised as soon as it's foreseen. If the resulting future revenue (advertising, research) cannot be assessed with reasonable certainty, the expenditure should be treated as an expense in the profit and loss account of the year in which it is incurred. There may be unpredictable sales in this time of recession as we have today; this may make it difficult for business' to apply the concept of prudence accurately when preparing their accounts. Thomas, A 1996

Managers should also not be over-optimistic in financial reporting, i.e. overstate profits, overstating profits is potentially dangerous because it can lead to a reduction of capital and dividends being paid out of profits that have not been earned.

The consistency is concept is also of vital importance for businesses. It makes things comparable, you treat similar items in a similar manner and the same treatment should be applied from one period to the next. This allows various stakeholders to look at your accounts and be able to compare with previous accounts. For example depreciation should be calculated the same way for every financial year and the purchase of certain tools and equipment should also be treated as fixed assets in subsequent years. This is to ensure meaningful comparisons can be made between different accounting periods and limit the possibility of misrepresentation. Thomas, A 1996

The business entity convention states that the business and its owner(s) are treated as being quite separate and distinct. It is necessary to record the business transactions separately from the owners' personal transactions. If the owner of a retail store decides to take a jacket for themselves, they must pay for it and make this evident in the company accounts, which will be added to drawings on the balance sheet. Atrill P, McLaney E 2004