Prudence and Accrual Concepts
It is from financial statements that users of
accounting information can make informed judgments about an entity. For
instance, potential investors would want to use the financial statements of
different entities (Wood and Sangster, 2012, pp.5-20). Similarly, existing
shareholders are interested in knowing the performance of the entity, thereby,
assessing whether the management is acting in the right way. Since accounting
is not an exact science, the information that goes into the preparation of
financial statements involves a great deal of judgment on those tasked with
such preparation (Hermanson, Edwards and Maher, 2011, p.33). To enhance the
reliability of accounting information, accountants use a number of concepts and
principles. What follows is an explanation of how the application of both the
accrual and the prudence concepts in measuring profits.
The Prudence Concept
This principle in accounting is sometimes
also called conservatism. It requires that caution should be taken in the
preparation of financial statements to ensure that there is no overstatement in
both the value of assets and net income respectively. In applying this concept
to the measurement of profits, the various components of profit measurement
must conform to its requirements. For example, it applies to the measurement of
both opening and closing inventory when the lower-of-cost-or- market rule is used
(Stickney, Weil, Schipper and Francis, 2010, p.884). To use the prudence
concept in measuring profits is, however, not the same as stating inaccurate
information. Thus, an accountant should be careful not to pass out the wrong
information just because the prudence concept was followed.
Since inventory constitutes one of the most
important components in measuring profits for merchandising businesses, it
becomes more appropriate to use it as an illustration(Albretch,Stice,Stice and
Swain,2007,pp.311-313). For one, both the beginning inventory and the closing
inventory go into the calculating of profit. The opening inventory is added to
purchases in a given financial period to arrive at the cost of goods available
for sale. An understatement or overstatement of that figure would mean that the
resulting cost of goods available for sale is also misstated. On its part, the
closing inventory helps in determining the cost of goods that was actually
sold. This is obtained by subtracting it from the cost of goods available for
sale. An overstatement in the closing inventory would result into a
corresponding overstatement in profits. The
lower-of-cost-or-market (LCM) rule as an aspect of the prudence concept
attempts to curb this problem. It values inventory by taking the lower value between
the historical cost and the market value (Duchac, 2009, p.277). Historical cost
normally refers to the value that a business used to bring the inventory into
the business while the market value is what the inventory can actually fetch in
a market sale.
Accruals
Just like the prudence, the accrual basis of
determining profits ensures that the figures reported are as realistic as they
can possibly be. It is the exact opposite of the cash basis of accounting. Under
the latter basis, a business entity only records transactions when there is
actual exchange of cash (Nikolai, Bazley and Jones, 2010, p.105). For instance,
a medical practitioner who offers a service to a client in December of 2011 and
receives the cash only in February of the following year would record nothing
about that transaction in 2012. Instead, that revenue will feature in the
determination of profits for February 2013 when the cash is actually received.
A business would normally record the items
relevant for the determination of profits in the normal cash basis. It is only
at the end of the given financial period when the need to determine profits
that adjusting entries are applied to the initial figures so as to arrive at
the accurate estimation of profits (Rich, Jones, Mowen and Hansen, 2009,p. 515).From
the perspective of profit measurement, adjusting entries ensure that the
reported revenue or expense is the proper one. Accruals are just one aspect of
end of period adjusting entries. The
need to keep in time with periodic reporting as well as the matching principle
is another reason to adjust financial entries (Lauz, 2007, pp.62-65). For
example, a user of financial statement may be interested in knowing the profit
relating only to a portion of the financial period while the relevant entries
relate to the whole period.
There are normally no previous entries on
accrued items. For profit measurement purposes, such items relate to the first
recording of revenues or expenses. An example of an accrued entry is where a
business has already rendered a service or sold a good and is yet to receive
payment for the same. The adjusting entry is to create an accrued asset account
equivalent to the value of that service or good and corresponding revenue.
References
Albretch,W.S.,Stice,E.K.,Stice,J.D., and
Swain,M.R.,2007.Accounting:Concepts and Applications, Tenth Edition.Mason,OH:South-Western
Cengage.
Duchac,W.R., 2009.Financial and Managerial Accounting, Tenth
Edition.Mason, OH:South- Western
Cengage Learning.
Hermanson,R.H.,Edwards,J.D.,&
Maher,M.W.,2011.Accounting Principles: A
Business Perspective, Eighth Edition.
New York: Global Text.
Lauz,J.,2007.Accounting Issues: An Essay
Series Part I-Introduction to Accounting Theory and Cash. Journal of College
Teaching and Learning,4(1),61-66.
Nikolai,L.A.,Bazley,J.D., and Jones,E.P.,
2010.Intermediate Accounting, Eleventh Edition.Mason, OH:Thomson.
Rich,J.S.,Jones,J.,Mowen,M.M., and Hansen,D.,
2009.Cornerstones of Financial Accounting.Mason, OH:Thomson.
Stickney,C.P.,Weil,R.L.,Schipper,K., and
Francis,J.,2010.Financial Accounting: An Introduction to Concepts,Methods,and Uses, Tenth Edition.Mason,OH:South-Western
Cengage.
Wood,F. and Sangster,A., 2012.Business Accounting 1,Twelth Edition.London:Pearson.
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