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Accounting Concept and Principles

Accounting Concepts and Principles are a set of broad conventions that have been devised to provide a basic framework for financial reporting. As financial reporting involves significant professional judgments by accountants, these concepts and principles ensure that the users of financial information are not mislead by the adoption of accounting policies and practices that go against the spirit of the accountancy profession. Accountants must therefore actively consider whether the accounting treatments adopted are consistent with the accounting concepts and principles.

In order to ensure application of the accounting concepts and principles, major accounting standard-setting bodies have incorporated them into their reporting frameworks such as the IASB Framework.

Following is a list of the major accounting concepts and principles:

1. Relevance:

Information should be relevant to the decision making needs of the user. Information is relevant if it helps users of the financial statements in predicting future trends of the business (Predictive Value) or confirming or correcting any past predictions they have made (Confirmatory Value). Same piece of information which assists users in confirming their past predictions may also be helpful in forming future forecasts.

Example:

A company discloses an increase in Earnings Per Share (EPS) from $5 to $6 since the last reporting period. The information is relevant to investors as it may assist them in confirming their past predictions regarding the profitability of the company and will also help them in forecasting future trend in the earnings of the company.

Relevance is affected by the materiality of information contained in the financial statements because only material information influences the economic decisions of its users.

Example:

A default by a customer who owes $1000 to a company having net assets of worth $10 million is not relevant to the decision making needs of users of the financial statements.

However, if the amount of default is, say, $2 million, the information becomes relevant to the users as it may affect their view regarding the financial performance and position of the company.

2. Reliability

Information is reliable if a user can depend upon it to be materially accurate and if it faithfully represents the information that it purports to present. Significant misstatements or omissions in financial statements reduce the reliability of information contained in them.

Example:

A company is being sued for damages by a rival firm, settlement of which could threaten the financial stability of the company. Non-disclosure of this information would render the financial statements unreliable for its users.

3. Matching Principle & Concept

A. Definition

Matching Principle requires that expenses incurred by an organization must be charged to the income statement in the accounting period in which the revenue, to which those expenses relate, is earned.

B. Explanation

Prior to the application of the matching principle, expenses were charged to the income statement in the accounting period in which they were paid irrespective of whether they relate to the revenue earned during that period. This resulted in non recognition of expenses incurred but not paid for during an accounting period (i.e. accrued expenses) and the charge to income statement of expenses paid in respect of future periods (i.e. prepaid expenses). Application of matching principle results in the deferral of prepaid expenses in order to match them with the revenue earned in future periods. Similarly, accrued expenses are charged in the income statement in which they are incurred to match them with the current period's revenue.

A major development from the application of matching principle is the use of depreciation in the accounting for non-current assets. Depreciation results in a systematic charge of the cost of a fixed asset to the income statement over several accounting periods spanning the asset's useful life during which it is expected to generate economic benefits for the entity. Depreciation ensures that the cost of fixed assets is not charged to the profit & loss at once but is 'matched' against economic benefits (revenue or cost savings) earned from the asset's use over several accounting periods.

Matching principle therefore results in the presentation of a more balanced and consistent view of the financial performance of an organization than would result from the use of cash basis of accounting.

C. Examples

Examples of the use of matching principle in IFRS and GAAP include the following:

• Deferred Taxation
  IAS 12 Income Taxes and FAS 109 Accounting for Income Taxes require the accounting for taxable and deductible temporary differences arising in the calculation of income tax in a manner that results in the matching of tax expense with the accounting profit earned during a period.
• Cost of Goods Sold
  The cost incurred in the manufacture or procurement of inventory is charged to the income statement of the accounting period in which the inventory is sold. Therefore, any inventory remaining unsold at the end of an accounting period is excluded from the computation of cost of goods sold.
• Government Grants
  IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires the recognition of grants as income over the accounting periods in which the related costs (that were intended to be compensated by the grant) are incurred by the entity.

D. Matching Vs Accruals Vs Cash Basis

In the accounting community, the expressions 'matching principle' and 'accruals basis of accounting' are often used interchangeably. Accruals basis of accounting requires recognition of income and expenses in the accounting periods to which they relate rather than on cash basis. Accruals basis of accounting is therefore similar to the matching principle in that both tend to dissolve the use of cash basis of accounting.

However, the matching principle is a further refinement of the accruals concept. For example, accruals basis of accounting requires the recognition of the estimated tax expense in the current accounting period even though the actual settlement of the provision may occur in the subsequent period. However, matching principle would also necessitate the recognition of deferred tax in the accounting periods in which the temporary differences arise so as to 'match' the accounting profits with the tax charge recognized in the accounting period to the extent of the temporary differences.

4. Timeliness of Accounting Information

Definition

Timeliness principle in accounting refers to the need for accounting information to be presented to the users in time to fulfill their decision making needs.

Importance

Timeliness of accounting information is highly desirable since information that is presented timely is generally more relevant to users while conversely, delay in provision of information tends to render it less relevant to the decision making needs of the users. Timeliness principle is therefore closely related to the relevance principle.

Timeliness is important to protect the users of accounting information from basing their decisions on outdated information. Imagine the problem that could arise if a company was to issue its financial statements to the public after 12 months of the accounting period. The users of the financial statements, such as potential investors, would probably find it hard to assess whether the present financial circumstances of the company have changed drastically from those reflected in the financial statements.

Examples

Users of accounting information must be provided financial statements on a timely basis to ensure that their financial decisions are based on up to date information. This can be achieved by reporting the financial performance of companies with sufficient regularity (e.g. quarterly, half yearly or annual) depending on the size and complexity of the business operations. Unreasonable delay in reporting accounting information to users must also be avoided.

In several jurisdictions, regulatory authorities (e.g. stock exchange commission) tend to impose restrictions on the maximum number of days that companies may take to issue financial statements to the public.

Timeliness of accounting information is also emphasized in IAS 10 Events After the Reporting Period which requires entities to report all significant post balance sheet events that occur up to the date when the financial statements are authorized for issue. This ensures that users are made aware of any material transactions and events that occur after the reporting period when the financial statements are being issued rather than having to wait for the next set of financial statements for such information.

Timeliness Vs Reliability - A Conflict

Whereas timely presentation of accounting information is highly desirable, it may conflict with the objective to present reliable information. This is because producing reliable and accurate information may take more time but the delay in provision of accounting information may make it less relevant to users. Therefore, it is necessary that an appropriate balance is achieved between the timeliness and reliability of accounting information.

5. Prudence

Preparation of financial statements requires the use of professional judgment in the adoption of accountancy policies and estimates. Prudence requires that accountants should exercise a degree of caution in the adoption of policies and significant estimates such that the assets and income of the entity are not overstated whereas liability and expenses are not under stated.

The rationale behind prudence is that a company should not recognize an asset at a value that is higher than the amount which is expected to be recovered from its sale or use. Conversely, liabilities of an entity should not be presented below the amount that is likely to be paid in its respect in the future.

There is an inherent risk that assets and income of an entity are more likely to be overstated than understated by the management whereas liabilities and expenses are more likely to be understated. The risk arises from the fact that companies often benefit from better reported profitability and lower gearing in the form of cheaper source of finance and higher share price. There is a risk that leverage offered in the choice of accounting policies and estimates may result in bias in the preparation of the financial statements aimed at improving profitability and financial position through the use of creative accounting techniques. Prudence concept helps to ensure that such bias is countered by requiring the exercise of caution in arriving at estimates and the adoption of accounting policies.

Example:

Inventory is recorded at the lower of cost or net realizable value (NRV) rather than the expected selling price. This ensures profit on the sale of inventory is only realized when the actual sale takes place.

However, prudence does not require management to deliberately overstate its liabilities and expenses or understate its assets and income. The application of prudence should eliminate bias from financial statements but its application should not reduce the reliability of the information

Adopted from: Accounting-Simplified.com