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Accounting practices have been developed gradually over the last centuries. All these years people who have never questioned whether alternative methods exists, which are just as valid, operate these procedures automatically. However, the procedures in common use imply the acceptance of certain concepts that are by no means self-evident, nor are they the only possible concepts. Further on we are going to refer to three of the concepts, which are identified as fundamental by the Companies Act 185 prudence, going concern and historical cost.
The prudence rule (which is sometimes know as conservatism) arises out of the to make a number of estimates in preparing periodic accounts. Managers and owners are often naturally over-optimistic about future events. As a result, there is a tendency to be too confident about the future, and not to be altogether realistic about the entity's prospects. There may, for example, be undue optimism over the creditworthiness of a particular customer. Insufficient allowance may therefore be made for the possibility of a bad debt. This might have the effect of overstating profit in one period and understating it in future period.
The periodicity rule requires a regular period of account to be established, regardless either of the life of the entity or of the arbitrary nature of such a period. The going concern rule arises out of the periodicity rule. This rule requires an assumption that an entity will continue in existence for the foreseeable future unless some strong evidence exists to suggest that this is not going to be the case. It is important to make absolutely certain that this assumption is correct, because a different set of accounting rules need to be adopted if an entity's immediate future is altogether uncertain.Order Custom Explain the following concepts:a) Prudence, b) Going concern and c) Historical cost paper
The main significance of the going concern concept is that the assets of the business should not be valued at their "break up" value, which is the amount that they would sell for it they were sold off piecemeal and the business were thus broken up.
The historical cost rule is an extension of the money measurement rule. It requires transactions to be recorded at their original cost. Subsequent changes in prices or values therefore are usually ignored. Increased costs may arise because of a combination of an improved product, or through changes in the purchasing power of the monetary unit, i.e. through inflation, that tends to overstate the level of accounting profit as it is traditionally calculated.
In general, accountants prefer to deal with costs, rather than with 'values'. This is because valuations tend to be subjective and to vary according to what the valuation is for. For example, suppose that a company acquires a machine to manufacture its products. The machine has an expected useful life of four years. At the end of two years the company is preparing a balance sheet and has to decide what monetary amount to attribute to the asset.
Numerous possibilities might be considered
a)the original cost (historical cost) of the machine,
b)half of the historical cost, on the ground that half of its useful life has expired,
c)the amount the machine might fetch on the second hand market,
d)the amount it would cost to replace the machine with an identical machine,
e)the amount it would cost to replace the machine with a more modern machine incorporating the technological advances of the previous two years,
f)the machine's economic value, i.e. the amount of profit it is expected to generate for the company during its remaining life.
All of these valuations have something to commend them, but the great advantage of the first two is that they are based on the machine's historic cost.
The greatest criticisms of traditional accounting concepts have stemmed from their inability to reflect the effects of changing price levels. In more detail the criticisms are
a)The most obvious example is property because the fixed asset values are unrealistic.
b)Depreciation is not provided for, in order to make retentions of profits and thus to ensure that funds are available for asset replacement.
c)Holding gains on stocks are included in profit for the year, despite the fact that during a year with high inflation the monetary value of stocks held, may increase significantly.
d)Profits or losses on holdings of net monetary items are not shown.
e)Comparisons over time are unrealistic, because a company's profit in past years may not be the same, as it seems compared with present profit if that profit has less money value.
1.University of Leicester Module , Diploma in Management, Accounting for Managers, 10th EDITION 001, Section , Accounting Concepts and Conventions
.J.R. Dyson, ACCOUNTING FOR NON-ACCOUNTING STUDENTS, 5th EDITION 001 Chapter , Accounting rules
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