The setting of accounting standards is a comparatively recent event. For decades there have been accepted concepts and conventions but no formal rules and standards. Why does accounting need concept and rule? This post tries to answer the question.

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The great majority of events and transactions are very clear and can be quantified by a very specific amount (of money). The event will clearly indicate whether there is a change in assets/liabilities/income or expense.

Consider the following case:

If a manufacturer sells equipment which costs 2,700 to manufacture for 4,000 cash, then there is a decrease in equipment finished goods inventory of 2,700 an equal Profit and Loss cost, sales of 4,000 and an increase in cash of 4,000. The reported profit of 1,300 and asset position in the balance sheet will be indisputably correct.

However, consider if the equipment which cost 2,700 to manufacture was sold to an overseas customer who pays 1,000 by immediate bank transfer and will pay the balance of 3,000 in three months time after delivery and satisfactory performance.

The overall figures are as above and the resultant profit and balance sheet figures should be the same. From today’s viewpoint the entire 2,700 inventory has gone, replaced by cash of 1,000 and a 3,000 receivable – but is this a ‘good’ asset – will the customer pay? It could be argued that income is earned in two stages 1,000 sales today with 3,000 sales in three months, this being confirmed by the customer accepting the item as in working order and paying! Maybe costs would have to be apportioned accordingly as well?

Such situations frequently arise in business and there is thus the need for clear rules as to how to account for and disclose transactions. It is important to realize that there is much convention based on experience, as to how items are disclosed. Although there have been abuses of the conventions with resulting scandals and frauds which have hit the headlines, most businesses are in a position to, and do, report clearly and fairly.

Some accountants and accounting authorities believe that it is possible to be highly prescriptive and set rules – accounting standards and guidelines for every situation. In the accounting standards issued by the International Accounting Standards Board (IAS), the view is that rules should be general in nature, leaving the fine detail of rule setting to business entities.

Accounting standard considered that there were four fundamental accounting concepts:

  • Going concern
  • Accruals or matching
  • Consistency
  • Prudence

These are described below as they remain important. The standard setters (US and International – the IASB which issues IAS’s and IFRS’s) have a “framework” on which to base accounting standards. This framework recognizes Going Concern and Accruals as “bedrock”. The other two plus other ideas and concepts are considered desirable qualities.

 

The Four Fundamental Concepts

Concept#1. Going Concern

The preparer (and auditor) of the accounts should consider and check whether or not the enterprise is likely to continue in operational existence for the foreseeable future. This means in particular that there is no intention or necessity to liquidate or curtail significantly the scale of operations and thus the P & L account and balance sheet will not be materially affected. For example, if a business which manufactures a product line on specialized equipment decides to cease manufacturing the product, the equipment will very likely cease to have and hold the value it did when this part of the business was “a going concern”.

The “going concern” concept also requires the preparer (and auditor) to consider and check that the business is likely to have cash/bank resources sufficient to remain in business for the foreseeable future – ‘foreseeable future’ is considered by UK auditing standards to be at period of at least 12 months beyond the date of signing the latest year end accounts.

 

Concept#2. Accruals or Matching Concept

Revenue and costs should be accrued (that is, recognized as they are earned or incurred, not as money is received or paid), matched with one another so far as their relationship can be established or justifiably assumed, and dealt with in the P & L account of the period to which they relate; with the proviso that where the accruals concept is inconsistent with the “prudence” concept the latter will prevail.

 

Concept#3. Consistency

There should be consistency of accounting treatment of like items within each accounting period and from one period to the next.

 

Concept#4. Prudence

Revenue and thus profits should not be anticipated, but should be recognized by inclusion in the P & L account only when realized either in the form of cash or of other assets which can be realized as cash with reasonable certainty.

Provision should be made for all known liabilities (related to expenses and present or future losses) whether the amount of these is known with certainty or is a best estimate in the light of the information available.

Referring back to the original example; how should the 3,000 (deferred) sale to the overseas customer be accounted for?

The fundamental concepts only give guidance. The two which are specifically pertinent in this case are the accruals and prudence concepts. From a timing (accruals or matching) point of view, is it correct to recognize the sale today? Probably yes, inventory has been sold (there should be paper work, a contract or at least an order and sales invoice).The further matter to consider is the quality of the 3,000 debtor; will the customer have a reason or find an excuse not to accept the equipment? Will the customer pay? Is it prudent to accept the 3,000 as an asset?

It may be necessary (prudent) to make some provision against the debtor not paying. This does raise the question as to why goods were sold to this customer in the first place!

The fundamental concepts are the basis from which detailed accounting policies are developed. Two frequently met situations where accounting policies are required are – depreciation of fixed assets and valuation of inventory/inventory and work in progress (WIP). Let’s go for some more details. Read on…

 

Depreciation: the Operation of Matching Concept

The exercise of depreciating a fixed asset is the operation of the matching concept. By definition a fixed asset is one that lasts for and is in use in more than one accounting period. It is a long-term asset in the balance sheet.

The fixed asset is used or consumed over its life and loses value. If nothing is done about recognizing the use, the asset will still be shown in the balance sheet with value – it is a “phoney” asset.

The exercise of depreciating assets is one of matching their use over their expected life.

fixed asset cost $15,000
zero value at end of 5 years
expected useful life 5 years – assumed to be used an equal amount each year of its working life
annual depreciation charge $15,000/5 = $3,000 per year

The cost of the asset can therefore be matched with the benefit/income arising from using it!

 

Inventory/WIP valuation Again Matching Concept

The exercise of counting or taking inventory at the end of an accounting period is again the matching concept in action.

materials purchased in the period = 8,500
inventory held at the end of the period = 800
therefore materials consumed into products in the period = 7,700

It would be incorrect to show all the materials purchased as a cost of production, those not taken into production or sold are an asset of the business, not a cost. This is of course assuming the inventory does hold value and can be used or realized in the next accounting period.

A question arises over “what figure to use for the value of inventory?

In the simple example above the conventional and normally correct figure is the cost of the remaining inventory or WIP should be valued at what it cost. However, if for some reason the inventory on hand had deteriorated or could be replaced at a (permanently) much lower price, then the inventory should be written down to its net realizable value (NRV).This is the prudence concept in operation.

It is obvious that if the inventory has deteriorated then it will not realize so much when ultimately sold. Equally if it was possible to purchase replacement inventory at a much lower price then the inventory held will not realize so much or maybe even its original cost on ultimate sale.

Much can be made of what is the cost of inventory or WIP. If inventory items are purchased piecemeal over time then what is the cost of the inventory at the period end? In the accounting standard it is generally accepted that inventory should be accounted for and therefore valued on a “first in first out basis(FIFO), that is remaining inventory is the most recently purchased. This seems entirely reasonable as inventory will be at an up to date cost. Also it is likely that the oldest inventory will be sold first.

With the possible range of figures, and particularly opinions as to what the cost or ultimate selling price might be, it will be appreciated that inventory/WIP valuation is a critical area for preparers of accounts and auditors. Inventory valuation is often a highly subjective area.

The fundamental accounting concepts are used as a basis for preparing the rules or accounting policies to be applied when preparing a set of accounts. For many businesses there is no great issue over the use of the fundamental concepts and rules – accounting policies based thereon. A small trading company would typically have the accounting policies, often as the first note to the accounts.