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Financial statements Accruals Prudence and Going Concern concepts

Discuss the problems for companies in applying the accruals, prudence and going concern concepts when preparing financial statements, and explain why at least two other concepts might also be important.
Accounting concepts and conventions as used in accountancy are the rules and principles applied when recording economic events and in the preparation of financial statements, that all accountants abide by. Some of the fundamental accounting concepts that will be discussed are the accruals, matching, prudence, going concern and consistency concepts.
In drawing up accounting statements, you have to make sure that they fairly reflect the true value of the business and the results of its operation. Whether they are external “financial accounts” or internally-focused “management accounts”, a clear objective has to be that the accounts fairly reflect the true value of the business and the results of its operation.
Therefore we use the ‘true and fair view’. The true and fair view is applied in ensuring whether accounts do indeed portray the business’ activities. To support this view, accounting has adopted certain concepts and conventions which help to ensure that accounting information is presented accurately and consistently. Accounting concept and conventions [online], Available from:, Date accessed 12/11/12.
Under the accruals concept revenue and costs are accrued (that is, recognized as they are earned or incurred, not as money is received or paid), matched with one another so far as their relationship can be established and recorded in the accounting records and reported in the financial statements of the periods to which they relate.. Thomas, A 1996, An Introduction to Financial Accounting, 2nd edition, McGraw-Hill
Having decided on the point at which revenue and expenses are recognised we turn to the matching convention. The matching convention in accounting is designed to provide guidance concerning the recognition of expenses. This convention states that expenses should be matched to the revenue that they helped to generate. Applying this convention may mean that a particular expense reported in the profit and loss account for a period may not be the same figure as the cash paid for that item during the period. McLaney E, Atrill P 1999, Accounting an Introduction, 3rd edition, Prentice Hall Europe
All expenses should be matched to the period for which the sales revenue to which they relate is reported. In practice, this may be difficult to do for certain expenses such as gas charges incurred, as this is unlikely to be linked directly to particular sales. As a result, the gas charges incurred would be matched to the period to which they relate. Let’s say that the gas company has yet to send out bills for the quarter that ends on the same financial year end. In this situation, an estimate will have to be made of gas expense outstanding. If the expense is predicted reasonably accurately it will have the desired effect of showing that, at the end of the accounting year. Businesses may face a difficulty in making an accurate prediction especially if it’s their first year in business or the usage of gas varies constantly.
Continuity (going concern) this states that in the absence of evidence to the contrary it is assumed that the business will continue into the indefinite future. This convention has a major influence on the assumptions made when evaluation particular items in the balance sheet. This allows us to assume that stock will eventually be sold in the normal course of business (at normal selling prices). It also allows for the principal of depreciation. If we assume a car will have a useful life to the business of five years, we depreciate this fixed asset over five years. Alexander D, Britton A 1999, Accounting An Introduction, 5th edition, Gray Publishing, Kent.
Problems may arise for companies applying the concepts of accruals and going concern. Under the accruals concept, revenue and costs are charged to the profit and loss account for the accounting period in which they were earned or incurred, not when cash is received or paid. Hence on the profit and loss account income or expenses shown is not what the business received/spent and then the concept of continuity attempts to spread the cost. Thus the concept displays a false picture as to what cash reserves are available within the business, which could result in serious cash flow problems. For example, the sales ledger may show many sales, while in reality the bank account may be empty because debtors haven’t paid yet, therefore the problems will arise when the debtors find it hard to pay off their debt, or delay in payment which will then affect the company’s working capital. Thus, the profit indicated in the annual accounts is unrealistic – as this shows a false picture on the actual business performance at the end of the financial year. The Isab Argues That The Accruals And Going Concern Concepts Are Key Underlying Assumption In The Preparation Of Financial Statements. [online], Available from: [Accessed: 12.11.2009].
Prudence is the exercise of a degree of caution when conditions are uncertain. The aim is to ensure that income and assets are not over-stated and expense and liabilities are not under-stated. Financial Accounting an Introduction 2008, Accounting An Introduction, Ashford Colour Press, Hampshire. The prudence concept dictates that if the resulting future revenue (advertising, research) cannot be assessed with reasonable certainty, the expenditure should be treated as an expense in the profit and loss account of the year in which it is incurred. Managers should also not be over-optimistic in financial reporting, i.e. overstate profits, overstating profits is potentially dangerous because it can lead to a reduction of capital and dividends being paid out of profits that have not been earned.
The prudence concept may be inconsistent with the matching principle and problems may arise for the business. Certain costs such as development expenditure should be carried forward to future years as a fixed asset and matched with the sales revenue generated by this expenditure. However, the prudence concept dictates that if future revenues are difficult to predict accurately, costs such as development expenditure should be written off to the profit and loss account in the year in which they are incurred. The business may overstate its expenses for the year when the benefit from the expense may be beneficial for many future years, like depreciation. Thomas, A 1996, An Introduction to Financial Accounting, 2nd edition, McGraw-Hill
The consistency is concept is also of vital importance for businesses. The consistency concept dictates that there should be ‘consistency of accounting treatment of like items within each accounting period and from one period to the next’. For example deprecation should be calculated the same way for every financial year and the purchase of certain tools and equipment should also be treated as fixed assets in subsequent years. This is to ensure meaningful comparisons can be made between different accounting periods and limit the possibility of misrepresentation. Thomas, A 1996, An Introduction to Financial Accounting, 2nd edition, McGraw-Hill

The Education In Reduce Audit Expectation Gap

Introduction The issue of “audit expectation gap (AEG)” has been very significant to the accounting profession since mid 1970s and continues to be debated until today. In the 1970s and 1980s, massive corporate failures have caused the accounting profession to be severely criticized by the public. For example, in 1973, Equity Funding – an insurance firm based in Los Angeles – collapsed when its computer-based fraud was discovered. In May 1982, Drysdale Government Securities collapsed followed by Penn Square Bank two months later. In 1985, the $340 million fraud in ESM Government Securities has been the largest securities fraud case ever to come before a US federal court at that time. Auditors were then forced to battle with legal suits taken against them. Meanwhile, the mounting list of corporate failures and abuses, alleged audit failures, and lawsuits against prominent accounting firms has generated concern outside the profession which subsequently called the House Subcommittee on Oversight and Investigations of the Committee on Energy and Commerce to conduct a hearing or congressional investigation of the profession, which was chaired by John Dingell, (“Management Accounting”, 1985). In defense, the profession defined the concept of AEG and focused public criticism on that concept.
The US accounting profession also responded to the scandals and criticism by appointing the Commission on Auditors’ Responsibilities (the Cohen commission) in 1974 and in 1978. The Cohen report concludes that there is an “expectations gap” between what auditors do and what the public expects of them. And then in 1986 the Anderson committee issues its report, Restructuring Professional Standards to Achieve Professional Excellence in a Changing Environment, in response to concerns over the profession’s ability to serve the public interest and retain public confidence. In 1987 The National Commission on Fraudulent Financial Reporting (popularly known as the Treadway commission) reports on how fraudulent financial management can be reduced and how auditors can reduce the “expectations gap” between themselves and the public (Mousselli, 2005). This is followed by the Accounting Standard Board released, in 1988, of nine “expectation gap” standards (SAS no. 53 through 61) which were intended to reduce the gap between what the informed public perceives auditors to be responsible for and what auditors regard their own responsibilities to be. However, those standards have not succeeded in closing the gap (Martens and McEnroe, 1991).
The profession has the view that, in general, the public believes that auditors should take more responsibilities in detecting fraud, illegal acts, and material misstatements and to perform better in communicating about the nature and the results of audits including giving early warning about the possibility of business failure (Guy and Sullivan, 1988). The nine new standards are believed to address these issues. The standards cover four broad categories: improving external communication, detecting fraud and illegal acts, making audit more effective, and improving internal communication. This also involves a new auditor’s report (Kolins, 1988). However, the public regards that auditors have a covenant with society to be responsible for the independent certification of financial statements. And one crucial way in which SAS Nos 56-61 fail to express the auditing covenant and, hence, fail to close the expectation gap, relates to auditors’ responsibilities with regard to illegal acts by clients (Martens and McEnroe, 1991).
Therefore, despite the profession’s efforts to address the issue of AEG, the gap still exists. As mentioned by the SEC’s Chief Accountant Michael Sutton, there were five “dangerous ideas” held by some accountants; one of it being “auditors have closed the expectation gap”. According to Steinberg in 1997, even the new auditing standards on fraud cannot be expected to totally close the gap. This is supported by Sikka, Puxty, Willmott and Cooper’s (1998) contention that due to social conflict, the meaning of social practices, such as audits, is subject to continuous challenges and renegotiations and the gap between competing meanings of audit cannot be eliminated. And so, in 2002, the profession is back under the spotlight following another series of corporate collapses that made history in the United States. As noted by Eden, Ovadia, and Zuckerman (2003), the criticism against the auditors is renewed with every public corporation’s failure and each financial loss the public takes.
The firm Arthur Andersen came to its demise because of its association with Enron, even though the verdict of obstruction of justice against the firm was overturned in 2005 by the United States Supreme Court (Moussalli, 2005). The crisis then led to the enactment of the Sarbanes-Oxley Act 2002 that is said to be “the most sweeping reform ever to affect the accounting profession” (Castellano, 2002). Now the accounting firms are regulated entities.
Those corporate crises led to new expectations and accountability requirements, and hence, create this called expectation gap. An expectation gap is detrimental to the auditing profession as highlighted by Limperg, 1933 (cited in Porter