Application of accounting concepts

During the year, the bookkeeper records transactions as they happen (cash basis). At year-end, the accountant ADJUSTS the records so they reflect the matching, prudence, going concern and other principles — converting cash-basis records into accruals-based financial statements.

Every adjustment has a CONCEPTUAL justification. Identifying it shows you understand WHY the adjustment is made — not just HOW.

The ten concepts (revisited from Topic 1.3) all apply at year-end:

• Business entity — owner's items stay out.
• Money measurement — only monetary items.
• Going concern — assume continuing operations.
• Historical cost — original purchase price.
• Realisation — revenue when earned.
• Accruals/matching — match income and expenses to period.
• Prudence — don't overstate; recognise expected losses.
• Consistency — same methods year on year.
• Materiality — focus on items that affect decisions.
• Duality — every entry has two sides.

Accrued expenses: an expense incurred but unpaid at year-end. The matching concept says: the cost belongs to the period it was consumed — regardless of payment date. Recognise an Other Payable.

Prepaid expenses: an expense paid for a future period. Matching says: only the current portion belongs in this period; defer the rest as an Other Receivable.

Income receivable: income earned but not received. Matching says: recognise it as income now AND as a current asset.

Income in advance: income received but not yet earned. Matching says: defer to next period as a liability.

Depreciation: the cost of a non-current asset is matched to the periods that benefit. Annual depreciation = matching the asset cost over its useful life.

All five adjustments use the same concept — accruals/matching.

Inventory at lower of cost or NRV: if NRV (estimated selling price minus completion/selling costs) is below cost, prudence requires writing down. Recognise the loss now; don't anticipate any recovery.

Provision for Doubtful Debts: even with no specific bad debts identified, experience shows some will go bad. Prudence requires recognising this expected loss as a provision (% of receivables).

Provisions for contingent losses: ongoing lawsuits, warranty obligations, restructuring costs — recognise as provisions when probable and measurable.

Asymmetry: prudence is asymmetric. Expected losses are recognised; expected gains are NOT (until realised — realisation concept). This creates a 'conservative bias' in the financial statements.

Going concern is the default assumption — the business will continue trading for the foreseeable future.

Implications for year-end valuations:

• Non-current assets recorded at carrying amount (Cost − Accumulated Depreciation), NOT at forced-sale value.
• Inventory at lower of cost or NRV in the normal course of business, NOT at fire-sale value.
• Receivables at expected collectable amount.

When going concern doesn't apply (business closing or in serious financial distress):

• Assets revalued to break-up / forced-sale value.
• Often results in large write-downs.
• The going-concern note in the auditor's report is removed; a 'liquidation basis' is adopted.

Exam questions sometimes test this: 'why is machinery shown at £12,000 carrying amount when its forced-sale value is only £4,000?' Answer: going concern.

Consistency: if straight-line depreciation was used last year for motor vehicles, use it this year. Change of method must be DISCLOSED with its effect.

Historical Cost: assets recorded at purchase price. The SOFP shows Cost − Accumulated Depreciation = Carrying Amount. Even if the asset's market value has tripled, the books show original cost.

Why consistency matters:

• Comparability across years.
• Reduces opportunity to manipulate profit by switching methods.
• Trends and ratios become meaningful.

Why historical cost matters:

• Objective (purchase invoice exists).
• Verifiable.
• Consistent across businesses (no need to guess current market value).

Materiality: information is material if its omission or misstatement could influence user decisions. Immaterial items can be simplified or aggregated.

Application: a £20 stapler with 5-year life — strictly capital expenditure, but materiality says expense it. Cost-benefit of accounting effort > the precision gained.

Business Entity: the business is separate from the owner. Owner's personal assets/liabilities stay OUT of the books.

Application: the owner's personal car parked at the business — not a business asset. Owner's personal mortgage — not a business liability. UNLESS the owner formally transfers it to the business.

For any year-end adjustment, use the NDAS framework:

1. NAME the concept (e.g., 'Accruals/matching').
2. DEFINE it (one sentence).
3. APPLY to the scenario (which detail in the case fits the concept).
4. STATE EFFECT on the IS and SOFP.

Example. Accrued electricity £400.

• Name: Accruals (matching) concept.
• Define: Recognise expenses in the period they are incurred, regardless of when paid.
• Apply: Electricity was used in December, even though the bill arrives in January.
• Effect: IS — Electricity expense ↑ £400. SOFP — Current liability (Other Payables) ↑ £400.

Following this structure: every concept-application question scores in the top band.