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Basic accounting concepts (Going concern concept (The practice of writing…
Basic accounting concepts
Going concern concept
The assumption that the entity will continue in operational existence for the foreseeable future
The assumption that there is no intention to close it and no intention to make significant cutbacks to the nature of the business
This approach means that the information provided by the financial statements is most relevant
The implication of this concept is that the assets of a business, ie buildings and equipment, will normally be valued at their historic cost ie their original purchase cost
The assets of the business should not be valued at their break up value (the amount they would sell for if they were to be sold one by one and over a relatively short period of time). The break up values tend not to be relevant to the users of accounts, who area assuming that the business will continue to operate over the remaining useful life of the asset
For example, if a business acquires machinery at a cost of £100,000 which is expected to last five years, it is usual to write off the cost of the asset over the five-year period against the profits to which the asset has contributed
The practice of writing off the cost of a long-term asset over its useful life helps to ensure that as the asset deteriorates physically or operationally, its value in the accounting records is reduced to reflect that loss
This is done over the life of the asset because it would be inappropriate to charge the full purchase cost to any single accounting period as the profit would be understated for that period while in subsequent periods the profit would be overstated
To show the asset at nil value in the accounts would be misleading, as it would imply either no asset or a valueless asset
The accountant must therefore have evidence that the asset will last beyond the end of the year
Applies to other assets such as stock and debtors where a similar assumption regarding the sale of stock or the collection of debt applies
Can also be applied to long-term loans or liabilities owed by the business, if the going concern concept were not applied, it is likely that these would become payable immediately and class as short-term debts or liabilities
The assumption that the business is a going concern really justifies the use of the historic cost concept, which in turn emphasises the high importance given to the qualities of objectivity and verifiability in accounting data
Accruals concept
Works on the principle that revenues and costs are matched with each other and dealt with in the profit and loss accounting of the accounting period to which they relate, irrespective of the period of actual receipt or payment
Profit is measured not by comparing cash received during the financial period with cash spent, but by matching expenditure incurred with income earned
States that when computing profit, the sales income earned should be matched only against the expenditure incurred when earning it
The prudence concept stresses that sales revenue should be 'realised' and 'recognised'' only when a critical event has occurred
When a cash sale is made
The goods are delivered or the services provided, and not when the sale proceeds are received , this will normally coincide with the date on the invoice or the date of delivery if the issue of the invoice is delayed
The accruals concept refers to this critical event as the point in time when the revenue is earned
Extended to the area of expenditure or costs
Costs should be recognised as arising when they are incurred and not when the cash is paid
For example, when an annual insurance premium is paid in advance and spreads across two years, care has to be taken that each financial year takes the appropriate share of the premium
Where an amount is paid in this financial year relates to the next financial year, there is a prepayment which will be carried forward to be charged in the subsequent year's accounts
Some services eg telephone, gas and electricity are seen as being incurred or used on the date they are received, at the end of a financial year these services will have been consumed or incurred but no invoice will have been received. These will be treated as accrued expenses
Shows profit/ loss as 'Revenue earned - Expenditure incurred = Profit (or loss) for an accounting period'
Prudence Concept
The principle that income is included in the financial statements only when realised, while likely losses are included as soon as possible
Where a selection has to be made between different procedures or valuations, the one selected should be that which gives the most cautious presentation of the financial position or results of the business
Follows that where a loss can be foreseen, it should be recognised and taken into account immediately
Reflect the traditional tendency for accountants to recognise likely losses as soon as possible but to defer recognition of potential income until it arises
Can be observed in the case of stock, stock should be valued at the lower of historic cost and net realisable value. Thus if the stock is likely to be sold for less than was originally paid for it, a loss will be made. The accountants recognise this loss immediately by reducing the value of unsold stock to net realisable value
Sometimes called the conservatism concept
Two reasons for following the prudence concept
Understating profit looks after the traditional interests of creditors and bankers
A conservative approach may counteract the natural optimism of some managers and owners
Consistency concept
The principle that there is uniformity of accounting treatment of like items within each accounting period and from one period to the next
Many pieces of accounting information are based on personal judgments i.e they are subjective
In certain area, ie the valuation of stocks or the estimation of bad debts, a company has a choice of several equally valid methods. These have different effects on reported profits from year to year
Firms may be tempted to take advantage of these alternatives to show an apparent improvement in their financial performance or strength, the use of the consistency concept provides a barrier to this being easily done
Once a company chooses a particular accounting treatment for an item, it must be applied consistently within each accounting period and from one period to the next for similar items
For example, it is assumed that the method of valuing closing stock is the same as that used to value opening stock
The company is allowed to change its accounting methods, provided there are good reasons for doing so. If it does, the effect on that years profit should be highlighted in the financial statements to facilitate comparisons with previous years
One aim of applying the consistency concept is to increase the usefulness of accounting information, the information can be compared with similar information about the company for some other period or point in time and with similar information about other businesses