The accruals concept states that revenues and costs should be recognised as they are earned or incurred irrespective of the period of receipt or payment. (Tony Davies and Tony Boczko 2005:p8)
In other words appropriate costs should be matched with appropriate revenues. This allows profits for an accounting period to be calculated without the need to wait for debtors to actually pay or to receive invoices from suppliers. This aids creation of financial statements (in time for publishing for companies) which are a legal requirement .Tax can then be charged appropriately and this avoids the tax man over charging or under charging tax. Invoices received for goods or services used at the end of the year are treated as liabilities because the firm owes these amounts to creditors or suppliers of goods and services. This concept saves time and allows a firm to access the current state of the business finances at a particular period or time.
However it is not always easy to apply this concept because it is difficult to know exactly the time to account for revenue received for example a sale of a good, is the revenue recorded when an order is made?, when it is delivered? , when the customer has accepted the goods? or when the money has been received by the business? It is not always easy to pin point the exact time to record revenue received. Same applies with costs and expenses; it is difficult to apply costs related to stock at hand and costs related to stock sold. The other fact is that the firm may not receive an invoice until start of another accounting period and this will result in a contradiction of the accruals concept because these costs will not have been matched to the period they occurred.
Prudence concept demands that losses should be provided as soon as they are known and profits should be recognised only when realised. Provisions must therefore be made for liabilities and expenses whether the amount are facts or uncertain, in accordance to the information at the business’ disposal. Stock should be valued at cost or net realisable value whichever is the lowest. (John Samuels, Colin Rickwood and Andrew Piper 1989: p13)
Provisions for items such as depreciation and bad debts will provide for amounts that might not be recovered from debtors if they declare themselves bankrupt and provision for depreciation will represent the wear and tear assets will incur during their use in the firm. Prudence will avoid over estimation of income and under estimation of expenses (Augustine Benedict and Barry Eliot 2011:p568). This will be useful to creditors like the bank who will require this information in order to reassure them that the firm will be able to pay its liabilities if a bank loan is taken. This will all add up and will result in a more equitable view of the firm’s accounts.
Every concept has a disadvantage; this concept is based on estimates and does not represent fact because the future holds uncertainty. This is therefore a defective method of dealing with uncertainty because it can be biased and estimates are based on the accountant’s view. Understatement of income can result in an overestimation of profit and this will have an indirect knock on effect in the future trends of profit (John Samuels, Colin Rickwood and Andrew Piper 1989:p13). Profit figures are always fluctuating and an accountant can take estimation to extremes so as to show a smooth trend of profit and this is misleading to shareholders and potential investors. This concept is also difficult to apply at times because it is hard to estimate factors such as life expectancy of an asset (to calculate depreciation) and one will need past information to base these estimates on for provisions. However this information is not always available if a business has only just started.
Accounting concepts sometimes contradict , the accruals concept states that revenues should be matched to the period in which they occurred but the prudence concept states that profit should only be shown when realised , this however means the concepts are not consistent which each other and this might become confusing to people who don’t understand accounting.
Going concern also goes against the prudence concept which states that there should be no over or under estimation of revenues and expenses, depreciation is based on an assumption or estimate and does not reflect the actual loss in value of an asset hence when assets are stated at historic costs they do not reflect loss in value over years in use. Depreciation under charged can result in a bigger profit and an under charged depreciation can result in lower profits, so this can have an indirect impact on the business as a whole.
Different concepts may contradict in some ways but overall the benefits of using them outweigh the costs or confusions they may present. These concepts will allow easy use of financial accounts and comparisons with other similar sized firms is also made easier.
References
Augustine Benedict and Barry Eliot, 2011, Financial Accounting an Introduction, 2nd Edition, Pearson: Essex
Tony Davies and Tony Boczko, 2005, Financial Accounting an Introduction, McGraw Hill: Maidenhead, Berkshire
Colin Rickwood and Andrew Thomas, 1992, An Introduction to Financial Accounting
John Samuels, Colin Rickwood and Andrew Piper, 1989, Advanced Financial Accounting, 2nd Edition, McGraw Hill Book Company: Maidenhead Berkshire
Pyle and White, 1972, Fundamental Accounting Principles, 6th Edition, Richard D. Irwin ,INC : United States of America
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tendy22 (student)
