Study Accountancy

Fundamental accounting concepts are enforced through accounting standards and/or company law.

• Going concern concept: This concept states that we must assume that a business will continue to operate for the forseeable future and it follows that we should use historical cost when valuing assets. In exceptional circumstances, however, we are able to reject this concept. For example, such curcumstances might include knowledge that a company is short of cash and is likely to cease trading shortly. In this circumstance we would prefer to value assets at their expected sale price.
• Consistency concept: Once a businesses has decided upon a method for the accounting treatment of an item, it will enter all similar items that follow in the same way. A business may decided to change its method for the accounting treatment of items, but this should not be done without a great deal of thought. If the change in method has a material effect on the values disclosed in the financial statements then the effects of the change should be stated.
• Prudence concept: Caution will be exercised when dealing with uncertainty, but not to the extent that financial statements cease to be neutral (i.e. don’t be more cautious than we need to be).
• Realisation concept: Rather than being a separate concept, this is usually considered to be subsidiary to the prudence concept. The realisation concept states that profits should only be taken into account when “realisation” occurs. Realisation occurs only when the ultimate realised cash is capable of being determined with reasonable accuracy (i.e. goods/services provided, buyer accepts liability to pay, monetary value is agreed, and the buyer is known to be in a position to pay). This is not the same time that the order is received or the time that the customer actually pays.
• Accruals concept: The accruals concept states that net profit is the difference between the revenues earned and the expenses incurred in generating those revenues (i.e. Revenues - Expenses = Net Profit). Determining the expenses used to generate revenues is known as “matching” expenses against revenues. Key to the appreciation of this concept is that all income and charges relating to the financial period to which the financial statements relate should be taken into account, regardless of the date of receipt or payment.
• Separate determination concept: This concept states that when determining the aggregate amount of each asset or liability, the amount of each individual asset or liability should be determined separately from all the rest. For example, a business with 3 machines would record in the balance sheet the sum of the individual values of the 3 machines.
• Substance over form concept: This concept states that if the legal form of a transaction differs from its real subsance then the accounting treatment should be in accordance with the real substance of the transaction. For example, a business undertaking the hire-purchase of a vehicle will not own the vehicle until all installments are paid and the option to take legal possession is exercised. However, from an economic point of view the vehicle will be used just as if it had been purchased outright. The correct accounting treatment would be to show the vehicle being bought via hire-purchase on the balance sheet as if it were legally owned by the business, but also to show separately the amount owed for it.

There are five underlying accounting concepts, which are reinforced through custom and practice:

• Historical cost concept: Assets are recorded at cost price within financial statements.
• Money measurement concept: Accounting information is concerned only with those facts which can be measured in monetary units and most people would agree to the value of the transaction. (This means that accounting can’t tell us everything about a business e.g. whether it has good managers or whether there are potential staffing problems).
• Business entity concept: Affairs of a business are to be treated separately from the affairs of its owners. The affairs of a business’ owners can affect the business is when they introduce capital or take drawings from it.
• Dual aspect concept: This concept states that the assets of the business are equal to the claims against the business (including the amount of capital owed to shareholders). This is an alternate way of stating the Accounting Equation (Assets = Capital + Liabilities). Double entry bookkeeping is the name given to the method of recording transactions under the dual aspect concept.
• Time interval concept: Financial statements are produced at regular intervals of one year. Many organisations choose to produce monthly statements for internal purposes.

In financial accounting it is necessary to attain the correct balance of objectivity and subjectivity when reporting financial information. In all cases, objectivity is to be preferred where possible.
The use of a method which gives a value everyone can agree on is said to be objective because it is based on factual occurrence. For example, the amount paid for a new vehicle. Everyone knows where the value came from and there will be ample evidence to support the value used in financial information.

Sometimes it is necessary to be subjective, usually because objective figures are not available. One example might be when trying to estimate the current value of a vehicle that was purchased for a known amount some years ago.

To ensure consistency when organisations are forced to be subjective, accountants follow a set of fundamental accounting concepts (or fundamental accounting principles) and these have been enshrined in relevant legislation and companies law.

There are a number of different types of users of financial information:

• Shareholders: Shareholders want to know how effectively the directors are performing their stewardship function, and will use financial information as the basis of decsions to buy or sell shares.
• The loan-creditor group (existing and potential debenture and loan stock holders, and providers of short-term funds): The loan-creditor group want to ensure that interest payments will be made promptly and that capital repayments will be made as agreed. Debentute and loan stock holders will want to know how easily they may dispose of their debenture or loan stocks should they so wish.
• Employee groups (existing, past and potential employees of the organisation, along with trade unions whose employees are members of the organisation): Past employees will primarily be concerned with the security of their pensions. Present employees will be concerned with whether the company can keep operating, continue to pay acceptable wages and maintain pensions. They may also want to ensure they are getting fair compensation for profits accruing as a result of their efforts. Potential employees may be trying to decide if the company is worth working for. Trade unions may use financial statements in wage and pension negatiations.
• Bankers: If a bank has not given a loan or overdraft to an organisation then it will have no great need to see the financial statements. If money is owed to a bank then that bank will want to ensure payments of interest will be made when due and that loans/overdraft will be repaid at the correct time.
• The business-contact group (trade creditors, suppliers, customers, business rivals, potential takeover bidders, and those interested in a merger): Trade creditors and suppliers will want to know if they will continue to be paid, and/or the prospects for future profitable association with the organisation. Customers want to know if a company is a secure source of supply. Business rivals will want to assess the comparative position. Potential takeover bidders and those interested in a merger would want to assess the desirability of such a move.
• The analyst/advisor group: This group will need information for their client or readers. Financial journalists need information for readers. Stockbrokers need information to advise investors. Credit agencies want information so they can advise present and possible suppliers to the company of its creditworthiness.
• Inland Revenue: Need financial statements to assess the tax payable.
• Other official agencies: Organisations concerned with supervision of industry and commerce may need the information for their purposes.
• Management: Vitally concerned with published (as opposed to internal) financial statements and the effects they may have.
• The public: Various groups with varying needs e.g. ratepayers, taxpayers, political parties, pressure groups and consumers.

Information is considered to be understandable if the significance of the information can be perceived by the expected user of that information. This can be aided by consideration of the user’s abilities and experience and through the aggregation and classification of detailed information into more useful summaries. It is reasonable to expect the user to have some general knowledge of business and economic activities and a willingness to study with reasonable diligence the informtion provided.

Information is comparable if it enables users to discern and evaluate similarities in and differences between the nature and effect of transactions and other events over time and between different business organisations. This is achieved through adherence to the consistency of financial disclosure required by law and also by the consistent application of the organisation’s own accounting policies.

Reliable information must be necessity be a complete and faithful representation of fact:

• Free from material error.
• Faithful representation of the substance of transactions.
• Neutral and free from systematic bias.
• Complete.
• Reported in such a way as to prudently (i.e. cautiously) take account of future uncertainty.

Information is relevant if it has the ability to influence a user’s economic decisions:

• Predictive value: Using analysis of past performance to predict future outcome.
• Confirmatory value: Checking past predictions.
• Choice of aspect: Contains all the information required to make an economic decision - not just one or two relevant items.

Materiality is a threshold quality of useful information, rather than being a primary qualitative characteristic which information must have if it is to be useful. Information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. For example, a large company may consider amounts below £1m immatierial (i.e. not material) whereas the owner of a small retail outlet may set a much lower materiality threshold, e.g. £100.

In the UK, the Accounting Standards Board has prepared a Statement of Principles that sets out what information is considered useful for making financial decisions. This information can be categorised as follows:

• Primary Statements: statements of financial performance; statement of financial position; cash flow statement.
• Notes to financial statements: accounting policies; analysis of figures in primary statements; information about any uncertainties affecting the financial position.
• Additional information: operating and financial review statement; chairman’s statement; directors’ report; historical summaries; non-accounting / non-financial information.
• Other methods of reporting: letters to shareholders; press releases; internet or other media activities.
• Miscellaneous: analysts’ reports; economic statistics; news articles.

Only the first two items in the list are relevant to Financial Accounting.