Over a period of time a number of conventions/concepts have been postulated by various bodies interested in financial statements. Many of these are incorporated in the above characteristics, but for completeness of your study we provide them here. These concepts are incorporated by preparers in current financial statements.
Prudence
Prudence is proper caution in measuring profit and income. Where sales are made for cash, profit and income can be accounted for in full. Where sales are made on a credit basis, however, the question of the certainty of profits or incomes arises. If there is not a good chance of receiving money in full, no sales are made on credit anyway; but if, in the interval between the sale and the receipt of cash, it becomes doubtful that the cash will be received, prudence dictates that a full provision for the sum outstanding should be made. A provision being an amount which is set aside via the profit and loss account.
Prudence is often exercised subjectively on grounds of experience and is likely, in general, to lead to an understatement of profit. The subjectivity involved can lead to variation between accountants in the amount of provision for bad debts, etc. and is bound to create differences between results obtained by the same general method of measurement. Users are therefore provided with pictures of various businesses which although apparently comparable, in fact conceal individual distortions.
Going Concern
As noted above, this concept assumes that the business is going on steadily trading from year to year without reducing its operations.
Consistency
This is one of the most useful concepts from the point of view of users who need to follow accounting statements through from year to year. Put simply, it involves using unvarying accounting treatments from one accounting period to the next – for example, in respect of stock valuation, etc.
You can only identify a trend with certainty if accounts are consistent over long periods; otherwise, the graph of a supposed trend may only reflect a lack of precision or a change of accounting policies. However, there will usually be changes or inconsistencies in accounting policies over the years and in public accounts it is essential to stress these changes so that users can make proper allowance for differences.
Money Measurement
Whether in historic or current terms, money is used as the unit of account to express information on a business and, from analysis of the figures, assumptions can be made by the users. As we have seen, though, this concept of a common unit goes only some way towards meeting user needs, though, and further explanation is often needed on non-monetary requirements – such as the experience of the management team, labour turnover, social policy.
Duality
Each item in a business has two accountancy aspects, reflected in its accounting treatment
as follows:
- Double-entry book-keeping requires each transaction to be entered twice – once as a debit and once as a credit. The debit represents an increase in the assets of the company or an expense, and the credit entry represents a reduction in the cash balance to pay for the item, or an increase in the level of credit taken.
- The assets of a business are shown in one section of a balance sheet and the liabilities in another. There is little to criticise in this duality, but we are looking behind the framework at the efficiency of the system and judging it by its success in meeting user needs. Duality falls short in the same sphere as money measurement, because there are areas in which it is not relevant.
Matching
Often considered the same as the accruals concept, matching calls for the revenue earned in a period to be linked with related costs. This gives rise to accruals and prepayments which account for the difference between cash flow and profit and loss information. This distinction will be clarified when you look at examples later.
Cost
As money is used to record items in the business accounts, each item has a cost. Accountants determine the value of an asset by reference to its purchase price, not to the value of the returns which are expected to be realised. Many problems are raised by this convention, particularly in respect of the effect of inflation upon asset values. This can also be considered as the historic cost concept.
Materiality
Accounting for every single item individually in the accounts of a multi-million pound concern would not be cost-effective. A user would gain no benefit from learning that a stock figure of £200,000 included £140 work-in-progress as distinct from raw materials. Neither would it make much difference that property cost £429,872 rather than £430,000. Indeed, rounded figures give clarity to published statements. So, when they are preparing financial statements, accountants do not concern themselves with minor items. They attempt rather to prepare clear and sensible accounts. The concept of materiality leaves accounts open to the charge that they are not strictly accurate, but generally the advantages outweigh this shortcoming.
Objectivity
Financial statements should be produced free from bias (not a rosy picture to a potential lender and a poor result for the taxman, for instance). Reports should be capable of verification – a difficult problem with cash forecasts.
Realisation
Any change in the value of an asset may not be recognised until the moment the firm realises or disposes of that asset. For example, even if a sale is on credit, we recognise the revenue as soon as the goods are passed to the customer. However, unrealised gains, such as increases in the value of stock prior to resale, are now widely recognised by non-accountants (e.g. bankers) and this can lead to problems with this concept.
Business Entity Concept
The affairs of the business are distinguished from the personal affairs of the owner(s). Thus a separate capital account is maintained in the business books, which records the business's indebtedness to the owner(s).
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