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FA Concepts

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13 views3 pages

FA Concepts

Uploaded by

Adam Barodawala
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Study Notes: Business Finance & Accounting

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 Accountants do not account for items unless they can be quantified in
measurement 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 Income should be properly "matched" with the expenses of a given accounting
"Accruals") 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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