Accruals Concept in Finance and Accounting
Length: 1306 words (3.7 double-spaced pages)
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However, problems might arise in companies applying the two concepts, accruals and the going concern. Firstly looking at the accruals concept, “Under the accruals concept, revenue and costs are credited or charged to the profit and loss account for the year in which they are earned or incurred, not when any cash is received or paid” (http://www.tutor2u.net/newsmanager/templates/?a=1373&z=82 ) . Therefore this manipulates the accounting statement in way that income shown is not what the business received and then the concept attempts to spread the cost. Thus the concept provides a false picture as to what cash reserves are available within the business, which could result in serious cash flow problems. For instance, the income ledger may show thousands of dollars in sales, while in reality the bank account is empty because debtors haven't paid you yet, therefore the problems will arise when the debtors finds it hard to pay off the credit, or they might delay with their payment due to unforeseen factors this will then affect the company’s working capital, which is the amount the business have for day to day expenses. Thus, the profit indicated in the profit and loss account or the balance sheet is unrealistic, in short terms this reflects a false picture on the actual business performance at the end of the accounting period i.e. yearly.
The main purpose of recording the business transactions, so called financial accounting is defined clearly in the Introduction to Accounting Book by Andrew Thomas 5th Edition: “Financial Accounting is the process of designing and operating an information system for collecting, measuring and recording an enterprise’s transactions and summarizing and communicating the results of the transactions to the users.” The part I want to draw attention on the definition is ‘communicating to the users,’ thus if there is a false reflection of the business cash or profit for the business at that short-term period, external users of the financial information i.
e. potential investors’ evaluation on the business performance whether to invest or not will be adversely affected. This is because business might not be able to payback the invested money due to its liquidation problems. Therefore in a way, if the accruals concept results in this, there is an element of deceitfulness in the accounts to show the exact performance of the firm at that point of time.
The concept also brings about the technique of “depreciation of fixed assets in the balance sheet and profit and loss account. The concept requires the firm to estimate the net cost of the asset (i.e. cost less residual value) and charge it to the periods expected to benefit from its use (i.e. its useful economic life). In other words, this technique will be matching the cost of using the asset with the revenue it helps to generate.” (http://www.accaglobal.com/students/publications/finance_matters/archive/2000/43/15563). The problem with this is when different methods of depreciation are used within the firm or for firms within the same industry. Therefore the firm can not compare to its competitors accurately as different method have been applied in their accounting statement, and also comparing the performance of the firm from its past year(s) might be inaccurate.
The problem for companies applying the going concern is that it affects the business activity, in terms of how the entity functions basing on its objectives. The concept assumes that the firm is going to remain in existence for and beyond the foreseeable future; therefore the main objective will be on continuity. Therefore techniques like depreciation are used when preparing the books of accounts, fixed assets will normally be shown in the balance sheet at cost less accumulated depreciation. The use of this concept also includes a large amount of judgement on the future basing on the information accessible at that point of time when the judgement is made. Therefore historistic information is used, however they are other external factors that affect the entity in future that are not taken in account, i.e. the inflation might affect the prices with in the market, therefore the residual value that is used for depreciation for the fixed assets, might not be what has been predicted, therefore the firm is likely to either over-value or under value its assets.
Nevertheless, in accounting they are other concepts used in companies, these include: the consistency convection, entity concept, prudence, diversity, materiality and monetary convection. I am going to talk about three of these that are considered to be important.
Firstly, the consistency concept is when the business has to apply consistency methods and policies when preparing accounting statements, this enables the business to make a sensible comparison year after year. It helps the firm in management within the company i.e. by making valid decisions using the information provided by the financial statement. They can also compare the present financial statements i.e. the balance sheet with the past year ones and can make judgement on the business performance by measuring the returned profit or the working capital to also reflect on the efficiency of the business. The consistency concept also helps the companies externally, in comparing of the annual performance/activity with other companies in the same industry i.e. its competitors. This will help the business in management decisions in order to be more competitive. The concepts also enable the users of the business financial accounting to be able to compare the businesses one performance over a certain time period, which will help in their decision marking e.g. potential investors.
The Entity concept is where by the business is treated as a different entity from the owner for financial purpose, by doing this; it helps in monitoring the financial performance or position of the business clearly with mixing the activities the owner and the actual business. The prudence concept helps the business to avoid overstatement of the profit by not valuing assets at highest possible estimate.
In conclusion, some of the concepts work side-by-side; in order to serve their purpose to the business e.g. (http://www.bized.co.uk/learn/accounting/infosystems/bait/work06.htm) “the fact that the firm should depreciate fixed assets is a direct consequence of applying the prudence concept and also the concept of accruals in order to match the cost of the asset the asset with the revenue it helps to generate. Once a firm has decided on a particular method (basis), this then becomes an accounting policy of that firm. The firm should then stick to that policy because of the consistency concept.” The importance of the concepts will depend on the type of the business e.g. a small firm might take less use on the accrual concept than the larger firms.
Introduction to Accounting Book by Marriott, Edwards& Mellett 3rd Edition
Introduction to financial accounting 5th Edition by Andrew Thomas
http://www.tutor2u.net/business/accounts/accounting_conventions_concepts.htm (reading the topic Accounting Concepts)