The UK standard SSAP 2- Disclosure of Accounting policies (ASSC,1971) defined accounting concepts as ‘broad basic assumptions that underlie the periodic financial statements of business enterprises. In this essay, I going to explore some of the key accounting concepts that dictate how financial information should be represented. Financial information is often complicated and involve a lot of transactions that can be manipulated either intentionally or unintentionally to disinform an organisation like the government or individuals like investors. In this article, I am also going to explore incidences where information is miscommunicated and the gravity of the action.
Going concern is the assumption that an entity will continue to operate. Users looking at an entity's financial statements have the right to assume that a company is not going into liquidation or decrease materially the scale of its operations. Any users should be able to examine past activity as a potential indication of future activity. It is assumed that all assets are valued at an appropriate measurement basis, including, historical cost, fair value or value-in-use, not just their scrap value. It is assumed that the entity will continue to operate for the remaining useful life of the non-current asset; henceforth, the asset's cost will be allocated to the statement of profit and loss over its useful life to be matched against the revenues the asset will help to generate. However, if the entity is going into liquidation, then all assets would be sold off, as a result of this the asset cost would be written down as part of the net revenue generated from the sale of the product. It is regarded as the most important concept as it ensures the organisation meet objectives and obligations to customers.
Carillion was a large construction company that went bankrupt in January 2018. It has previously issued a profit warning 6 months before the collapse. External auditors KPMG gave Carillion a clean bill of health despite the 2016 pension scandal acting as a potential red flag, the incident even involved the Pension's Regulator. The collapse resulted in 27,000 employees losing out on their pension scheme. Auditors failed to recognise that Carillion is no longer a going concern and makes any suitable adjustments to the account to reflect this.
This concept is concerned with allocating expenses and income to the periods associated. This means the expenses are matched to the period they were used by the entity and income to the period which it was earned. This is different to when cash is paid out for expenses (trade payables) or when cash is received from the sale (trade receivables). According to the Conceptual Framework, it states that ‘accrual accounting depicts the effects of transactions and the circumstances on a reporting entity's economic resources and claims in the periods in which effects occur, even if the resulting cash receipts and payments occur in a different period'. In terms of sales revenue, the application of the accrual principle has typically been referred to as revenue recognition, which defines sale as the exact time a good are delivered or services are provided. In practice, it is also the date of the invoice. However, if an invoice is rendered after the date of the delivery the sale would be defined by the date of delivery, not the invoice date.
The other factor that was wrong with Carillion's financial account was the use of aggressive accounting for revenue recognition and the valuation of their investment which distort its financial position making it look stronger than it was. Carillion likes to undertake many risky projects while valuing the investments highly with no guarantee of returns. Furthermore, they faced payment delays in the Middle East.
It is the assumption that profit that hasn't been earn yet isn't included in the financial statement and that any outstanding trade receivables can be expected with reasonable certainty. Expenses and liabilities are complete and are not understated or overstated. The prudence concept is one of the popular to manipulate. When companies did well, they tended to overstate expenses via creating provision for large expenditure and understating revenue and vice versa when the company are weak. As a result of this, the performance of an organisation could not be interpreted as accurately and as confidently.
The entity concept is also known as the accounting entity or the business entity. All businesses whether a corporate, partnership or sole trader are given a separate entity for accounting purposes. It allows the user to analyse the reporting entity's financial statements and to know that these only represent the performance of the business. It is assumed that no assets, liabilities, income or expenditure that is not associated with the business entity are included. Thus, if a sole trader were to use the business cheque to buy a car for personal use, the transaction will not form part of the business's assets and will be regarded as owner withdrawing equity capital which is known as ‘drawing'.
Substance over form concept
All rights and obligation arising from a transaction are identified in a way that reflects its economic substance not just its legal form. This rule was introduced to try to prevent the accounting practice that had emerged from creating a complicated legal transaction which, because of their legal form, allowed transactions to be omitted from the financial statements. Particularly, liabilities were presented in such a manner to enable them to be omitted from the statements, thus making the company look stronger while masking the real debt commitment from users. The preparer of the financial statements has to determine whether the transaction acts as an asset or a liability as defined in the Conceptual Framework (IASB, 2018). For example, leasing, where a company contracted to lease a good like a motor vehicle at a given monthly rental agreement for a set period, after the period the company will have the option of purchasing the product for an extra price. If the legal form took precedent then the rental payments would be accounted as an expense rather than as non-current assets, hence misrepresenting the nature of the transaction. This is a form of off-balance sheet finance. However, in economic terms, the substance of this transaction is the purchase of a vehicle payable by instalments, similar to a hire purchases transaction. Thus, the substance characteristic dictates that the rental payments are not recorded as an expense but are capitalised as a finance lease liability. The ownership of the vehicle is therefore passed to another party but the entity still has access to all future economic benefits.
- Thomas and Ward (2019) Introduction to Financial Accounting
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