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Introduction
Accruals
Consistency
Prudence
Materiality
Realisation
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Accounting Concepts

Conflicts in Accounting Concepts and Conventions

Introduction

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In recording transactions, certain concepts and conventions have been almost universally accepted by the accountancy profession. Although some of these policies, concepts and conventions may be termed differently by different individuals and various accounting bodies, there is a general agreement about their meaning and interpretation as well as scope of application. The International Accounting Standards Committee, which is supported by many countries, has also covered most of these concepts and considerations in its first standard (IAS 1) on Disclosure of Accounting Policies.

Despite the fact that most of the concepts have been universally accepted, accountants quite often come across situations where two concepts are in conflict and one overrides the application of the other. These are situations where an accountant will find it necessary to apply his professional skill and judgement to come up with the best possible solution. To quote from IAS 1,

"There are many different accounting policies in use even in relation to the same subject: judgement is required in selecting and applying those which, in the circumstances of the enterprise, are best suited to present properly its financial position and the results of its operation."

This article will deal with some of these conflicting situations and discuss the proper interpretation of ideas in similar circumstances. I will now discuss some of the conflicting situations when other considerations overrule the application of a certain concept.

Materiality

The materiality concept does not apply while recording cash transactions. Thus, small amounts cannot be omitted from the cash book on the grounds that they are not material. As a general rule, therefore, every cash transaction has to be recorded in the cash book - regardless of the materiality of the amount involved.

Again, the principle of materiality does not hold good when errors of principle are detected which need correction. If it is discovered that a capital item has been erroneously expensed, or a different method of depreciation other than that used in previous years has been applied for a particular asset, the errors should be corrected immediately. The concept of materiality cannot be used as a defence for not correcting the errors.

Consistency

The same rule applies for the consistency concept as applies to the materiality concept. Once an error is discovered in the books, it has to be corrected immediately, despite the fact that similar errors may have been left undetected in a number of prior periods accounts. The fact that the error consistently remained in the books for a considerable period of time should not in any way encourage an accountant to advocate the consistency concept - thereby allowing the error to remain uncorrected.

However, within the general framework, judgement may have to be applied for amounts which are not material. In other words, the materiality concept may be recognised so long as it is not in conflict with Generally Accepted Accounting Principles (GAAP). Thus, it is possible for an organisation to follow the principle of capitalising capital expenses and yet expense out capital expenses items which cost less than a predetermined limit, say 400, or where the expected life of the asset does not exceed, say, 3 years.

Accruals

Another principle followed by accountants relates to matching costs with revenue. Expressed simply, all related costs should be matched with the corresponding revenue and should be accounted for in the same time period in which the revenue is recognised. A good example would be the treatment of deferred revenue expenditures that are usually spread over a number of years, during which the organisation is expected to earn additional revenue out of the expenditure.

While this treatment is an accepted principle, there may be a counter-treatment, argued by another group, to charge the item as an expense, the entire amount in the year it was spent, on the grounds of conservatism. In other words, there may be a direct clash between the accruals and conservatism principles. To resolve such an issue, the professional accountant would first look at the two concepts discussed earlier, that is, materiality and consistency. In this case, the concept of conservatism may be applied if it passes the other two tests of materiality and consistency.

Prudence

Although the accruals concept is universally accepted in trading and manufacturing organisations, there are occasions when the concept of conservatism overrides the application of the accruals concept. A typical example would be the accounts prepared for professional firms of accountants, lawyers and medical practitioners. In these accounts, recognition is generally given to the accruals concept insofar as it relates to expenses. In computing the incomes, however, a rather conservative approach is followed and only those items that are actually realised are accounted for in the accounts. This treatment has been accepted by the accountancy profession on the grounds of conservatism, although it generally defeats the concept of the accruals concept.

When the accountant has a choice between two alternative treatments, remember, he should select the one that shows a less encouraging position of the financial situation. To follow the principle of conservatism is not easy; and good judgement is necessary to decide the right course of action.

There is however, a great deal of difference between being conservative and being over conservative. The rule of conservatism should not be stretched to the point where it might eventually result in distorting the financial results. For example, capital items such as buildings, vehicles, machinery etc, which are capitalised in accordance with GAAP, must always be capitalised and no deviation should be recommended on the grounds of conservatism.

Realisation

A conflict of concepts can also be seen in cases of revenue recognition and the valuation of closing stock. The general principle for valuation of inventory is to take the lower of cost and realisable value. This is a conservative approach whereby no profit is anticipated on inventory and at the same time any possible loss that may be foreseen is accounted for immediately. Although this is the generally accepted method, some exceptions have been granted by the profession for different industries. These exceptions, in the form of a relaxation of the conservative approach, have been accepted on the grounds that they will help reflect a true and fair position of the statement of account.

In cases of long-term contracts and hire-purchase agreements, where the exact profit can only be ascertained on completion of the contract or agreement, it has been the practice to declare a proportionate profit before completion of the contract, provided the computation is conservative and followed consistently. To take another example, in some plantation industries where the sale proceeds usually vary considerably, due recognition is given to post-balance sheet events in so far as revenue is concerned. Thus, valuation of the closing stock is based on

  • actual realisation for that part of inventory sold after the balance sheet date; and
  • the principle of lower of cost and realisable value for the balance of unsold inventory
On these occasions, while the conservative approach is maintained, it has been considered appropriate to make a deviation for the benefit of users of financial reports.

Conclusions

For the purpose of this article, only a few typical illustrations have selected. There may be many more situations where two or more concepts either overlap or contradict. It must be understood that there is no right or wrong answer for these problems - much depends of the volume and nature of the transaction, as well as the business to which they relate.

Contrary to general belief, the accountancy profession, like any other profession, is very flexible with great reliance being placed on the professional education and practical experience of members concerned. Every accountant is expected to apply his judgement in the best interests of the general public.

I have to confess that I am not sure who wrote this article. I have edited it, however, since there were several syntactical and other errors; but I will not claim authorship of it. This does not mean that we can copy it willy nilly, even though I have posted it here. If the author can prove that this work is his, I will gladly withdraw it or make the normal acknowledgement of authorship.

Duncan Williamson
3 September 2001 revised 18 November 2001 revised August 2003

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