Contents: 6 sections
Syllabus points
- Explain the accounting concepts and apply them to given situations.
- Explain how a concept determines the treatment of a particular transaction.
- Identify which concept has been broken by a stated accounting treatment.
Why these are examined the way they are
Questions rarely ask "define prudence". They describe a treatment and ask which concept supports it, or which concept it breaks. So learn each concept attached to the treatment it produces, not as a definition on its own.
The concepts
Business entity. The business is separate from its owner. Only business transactions are recorded. The owner's private car is not an asset of the business, and money the owner takes out is drawings rather than an expense.
Money measurement. Only items with a monetary value are recorded. This is why the skill of the workforce, the loyalty of customers and the quality of management never appear in the accounts, even though they may matter more than anything that does.
Going concern. The business is assumed to continue for the foreseeable future. This is what justifies carrying non-current assets at cost less depreciation rather than at what they would fetch in a forced sale. If the assumption fails, assets must be restated at net realisable value.
Accruals, also called matching. Income and expenses belong to the period they relate to, not the period they are paid in. This produces every year-end adjustment: accruals, prepayments, depreciation and closing inventory all exist because of this one concept.
Consistency. The same treatment is used from year to year, so results can be compared. A business may change its depreciation method, but it must have a reason and must disclose the change.
Prudence. Do not overstate assets or profit; do not understate liabilities or losses. Provide for a foreseeable loss as soon as it is likely; recognise a gain only when it is realised. This is why an allowance for irrecoverable debts is created and why an expected profit on a future sale is not.
Materiality. An item is material if leaving it out or misstating it would change a user's decision. A $12 stapler with a five-year life is technically a non-current asset, but writing it off as an expense is acceptable because the amount changes nothing.
Realisation. Revenue is recognised when the goods or services pass to the customer and the risks and rewards transfer, not when the order is placed and not when the cash arrives. A signed order for $50 000 next year is not this year's revenue.
Duality. Every transaction has two effects of equal value. This is the basis of double entry and of the accounting equation.
Historic cost. Assets are recorded at what was paid for them. It is objective and verifiable, which is its strength, but it means the statement of financial position does not show current values, which is its weakness.
Substance over form. Record the commercial reality rather than the legal form. An asset held on a finance lease is shown as an asset of the business even though the business does not legally own it, because in substance the business has the benefits and the risks.
Concepts that pull against each other
Examiners like this, and a good answer names the tension rather than reciting both concepts.
- Prudence against accruals. Accruals says match income to the period earned; prudence says do not recognise it until it is reasonably certain. Prudence wins where there is doubt.
- Prudence against consistency. Being more cautious than last year makes the years harder to compare.
- Materiality against accruals. Strict matching says accrue the $3 of unused stationery; materiality says do not bother.
- Historic cost against relevance. Cost is reliable but can be badly out of date, which is why the concept is criticised in periods of inflation.
Matching the treatment to the concept
| Treatment | Concept behind it |
|---|---|
| Closing inventory valued at the lower of cost and net realisable value | Prudence |
| Rent paid in advance carried forward to next year | Accruals |
| Owner's holiday not recorded in the accounts | Business entity |
| Non-current assets depreciated rather than written off at once | Accruals and going concern |
| Same depreciation method used each year | Consistency |
| Skilled staff not shown as an asset | Money measurement |
| Small tools charged to the income statement | Materiality |
| Deposit received for goods not yet delivered treated as a liability | Realisation |
| Leased asset shown on the statement of financial position | Substance over form |
Common mistakes
- Saying prudence means understating profit deliberately. It means not overstating it.
- Explaining a concept in the abstract when the question gives a scenario. Apply it to the scenario given.
- Using going concern to justify the accruals adjustments. Accruals is the concept behind those.
- Saying money measurement means everything is measured in money, without drawing the conclusion that some real assets are therefore excluded.
- Confusing realisation with the receipt of cash.