Accounting Concepts and Conventions
Financial accounting versus management accounting
Financial accounting involves collecting, recording, analysing and presenting financial information to different users. The accounts are prepared to comply with International Financial Reporting Standards (IFRS)for ease of analysis in terms of layout and terminology. Users can be internal such as managers and workers or external such as creditors, banks and the government. Financial accounts record past financial transactions and are prepared once or twice a year while the collection of data occurs daily.
Management accounting is a branch of accounting that makes financial information available to assist management in decision-making. It is for internal use and does not need to conform to any format stipulated by regulation and IFRS. It covers both past and future periods and is usually prepared when required.
Accounting concepts and conventions
These are principles that have evolved to regulate the preparation of financial accounts. They have become generally accepted that they have become incorporated in accounting standards all over the world.
The owners of a business or those who have economic interests in the business are distinct from the business in accounting. Therefore, a business has a separate legal existence from its owners. Only the income, expenses, assets and liabilities that pertain to the business are recorded in its books of accounts. For example, if an owner withdraws money from the business and uses it to pay for his expenses, it will not be recorded in the expense account of the business. Rather the money would be treated as withdrawal from the capital he has invested in the business and recorded in a drawings account.
Only transactions that are capable of being expressed in monetary terms are recorded in the financial statements. Any item that cannot be measured and assigned a monetary value should not be recorded in the accounting records. Qualitative data such as talented workforce cannot pass through the books of accounts because they cannot be quantified and used to determine the financial status of the business.
There are many ways to value the assets of a business, e.g. market value, net realisable value, etc. The most reliable value of an item is the cost incurred when it was originally purchased, known as historical cost. Though the value of an asset may depreciate over the years, it is required for assets to be recorded first at the cost of acquisition. Therefore, long-term assets are usually shown in the accounts at historical cost first. This serves as the basis for ascertaining whether their values have increased or decreased in subsequent years.
Financial statements are prepared on the assumption that the business will not cease operations in the foreseeable future and that the management has not envisaged a future event that could lead to the end of the business. If the management has knowledge of any event that could lead to the termination of the business, its assets would be recorded at what they can fetch in the market (realisable value) not historical cost.
This means that a business should exercise caution in recognising profits but all known losses should be adequately provided for. This is to ensure that profits and assets are not overstated. Revenue, for example, is only recorded when it is certain that value has been passed or obtained.
A business must recognise a transaction when it can be objectively measured or when the value due in exchange is fairly certain. For instance, value is certain when goods are delivered to the customer or the customer receives the goods.
Only the revenues pertaining to an accounting period must be matched against the costs for the period even when payment is not effected in the same period. This is the basis of accrual accounting which requires transactions to be recorded for the period they relate to even though payment is deferred to a subsequent period.
A business should give strict accounting treatment to only items that are tangible or material. Items are tangible or material if they have an effect on the information presented to the users of the financial statements. Items are adjudged immaterial if they are small in relation to the size of the business and they have an insignificant effect on it. For example, a business that makes a profit of $500 million per year will not retain an asset that costs $5,000 in its accounts like other assets but written off in the year it is purchased.
Though some items require some judgements on the part of the management of the business, financial statements should be prepared based on facts or verifiable evidence as much as possible. They should not be subjective by being based on the opinions of either the accountant or management of the business. This leads to misrepresentation to those that use the financial statements for decision-making.
There are many users of financial statements, e.g. shareholders, creditors, government and managers. These users have different needs and the business should not prepare its accounts in such a way that they are beneficial to a particular user. Consequently, a business should prepare its financial statements in compliance with relevant accounting standards and principles.
The accounting treatments for a transaction are usually more than one. Once a business selects a method of recording a transaction, it should stick to it in subsequent years unless there is a condition that warrants a change. This ensures that useful comparison can easily be made over the years.
Every transaction in accounting has two sides, the receiving/debit side and the giving/credit side. For example, when a motor vehicle is bought for cash, the value of motor vehicle (an asset) will increase (debited) while cash (another asset) will decrease (credited) by the same amount. This is also called the double entry principle.
Substance over form
Transactions should be given accounting treatment based on their financial reality which could contradict their legal form. This is to ensure the financial statements are not misleading to the users. The legal principles governing business transactions may differ from accounting principles. For example, an asset obtained by a business on hire purchase does not legally belong to the business until all instalments are settled but it is treated as an asset of the company in the accounting records from the onset. This is because the business uses it to generate income like other assets bought outrightly but it only chose a diffent way to finance it.
Although the most reliable time to determine the profitability of a business is at cessation, the lifespan of a business must be split into accounting periods to enable us to measure the results without waiting until liquidation. An accounting period is usually a 12-month period or a year. The only exceptions are when preparing the first final accounts after commencement, preparing the last final accounts after cessation of business and there is a change of accounting period.