Study Notes: Application of Accounting Concepts (Adjustments Focus)
👋 Welcome, Accounting Whizzes!
This chapter is super important! If adjustments (like accruals and depreciation) feel like magic, it’s because they are all based on strong rules—the Accounting Concepts. Think of these concepts as the fundamental laws of business reporting.
Why is this relevant to our current section ("Accounting for end of period adjustments")? Because every single adjustment we make—like adjusting for rent paid in advance or recording depreciation—is done to ensure we follow these concepts, especially the concept of Matching and Prudence. Let's dive in!
The Core Concepts That Drive Adjustments
The goal of applying these concepts is simple: to make sure the profit calculated for the year is as True and Fair as possible.
1. The Matching (or Accruals) Concept
This is arguably the most crucial concept when dealing with end-of-period adjustments (Accruals and Prepayments).
The Rule: Expenses incurred in a period must be matched against the Revenue earned in that same period.
It doesn’t matter when the cash was paid or received; what matters is when the economic activity happened.
The Analogy (The Dinner Party):
Imagine you are hosting a dinner party in December (your accounting period).
- You bought the food in November (paid cash early).
- You only used the electricity bill that arrives in January (paid cash late).
Application in Adjustments:
The Matching Concept forces us to use Accruals (recording expenses/revenues incurred but not yet paid/received) and Prepayments (recording expenses/revenues paid/received but not yet incurred/earned).
Example: If you pay £1,200 for 12 months of insurance on 1st October, by 31st December, only 3 months' worth (£300) belongs in this year's Income Statement. The remaining £900 is a Prepayment (an asset) carried forward to the next year.
🔑 Quick Review: Matching Concept
Goal: Find the right profit for the right period.
Action: Match costs with the revenue they helped generate, regardless of when cash changed hands.
2. The Going Concern Concept
Don't worry if this sounds complicated—it's very straightforward!
The Rule: Financial statements are prepared on the assumption that the business will continue to operate for the foreseeable future and will not be forced to stop trading or significantly reduce its scale of operations.
The Analogy (Buying a Textbook):
When you buy an expensive textbook for your GCSEs, you expect to use it for two years, not throw it away next week. You treat it as a long-term resource.
Application in Adjustments:
If the business was expected to close next month, all its assets (like machinery) would be recorded at their immediate selling price (scrap value). Because of Going Concern, we treat assets as long-term investments and spread their cost over their useful life through Depreciation.
If we didn't use Going Concern, we wouldn't need depreciation! We would just write off the entire cost of the machine in year one.
3. The Prudence (or Conservatism) Concept
This concept tells us to be cautious and realistic when calculating profits and valuing assets.
The Rule: Accountants should be cautious when preparing financial statements.
- Anticipate (or provide for) all losses, even if they haven't happened yet, as long as they are likely.
- Do NOT anticipate (or record) profits until they are actually realised (i.e., earned and certain).
The Analogy (A Weather Forecast):
If the forecast says there’s a 70% chance of rain (a potential loss), you take your umbrella (you prepare for the loss). If the forecast says there’s a 70% chance of sunshine (a potential gain), you don't start celebrating your perfect beach day until the sun is actually shining!
Application in Adjustments:
This concept is critical for ensuring assets and profits are not overstated:
- Valuing Inventory: Inventory must be valued at the Lower of Cost or Net Realisable Value (NRV). If the selling price (NRV) drops below what you paid for it (Cost), Prudence demands you write down the value immediately (anticipating the loss).
- Provision for Doubtful Debts: Prudence tells us that even if a customer hasn't officially gone bankrupt, if we think they are unlikely to pay, we should create a Provision (anticipating the loss) to reduce the value of our debtors.
🚨 Common Mistake to Avoid!
Prudence DOES NOT mean deliberately trying to make your profit look smaller than it is. It means being realistic and cautious so you don't mislead investors by showing profits or assets that might not actually exist.
4. The Consistency Concept
Imagine if a business changed how it calculated depreciation every single year—it would be impossible to compare this year’s performance to last year’s!
The Rule: Once a business chooses an accounting method (e.g., Straight-Line Depreciation or Reducing Balance Depreciation), it must use that method consistently from one accounting period to the next.
Application in Adjustments:
This concept ensures that:
- Depreciation: You cannot jump between straight-line and reducing balance methods simply because one gives you a higher profit this year.
- Inventory Valuation: If you choose the FIFO method, you must stick with FIFO unless there is a very good reason to change (and this change must be disclosed).
Consistency makes sure that changes in profit are due to real business performance, not just changes in accounting methods.
Putting It All Together: Concepts and Adjustments
When you are tackling adjustments in your exams, always remember which concept is driving the need for that adjustment:
| Adjustment Type | Driving Concept | What is achieved? |
|---|---|---|
| Accruals & Prepayments | Matching (Accruals) Concept | Profit is calculated based on activity, not cash flow. |
| Depreciation | Going Concern Concept | Cost of long-term assets is spread over their useful life. |
| Provision for Doubtful Debts / Inventory write-down | Prudence Concept | Anticipating likely losses; preventing overstatement of assets/profit. |
Did you know? These fundamental concepts are essential not just for preparing accounts, but for auditors (the people who check the accounts) to ensure the financial reports are reliable. They are the backbone of all good financial practice!
Quick Knowledge Check
If a business fails to account for three months of electricity used but not yet billed, which concept is being violated?
Answer: The Matching (Accruals) Concept, because the expense was incurred in this period and must be matched against the revenue earned, even if the cash payment hasn't been made yet (an Accrued Expense).
Keep practicing applying these rules, and your adjustments will start making perfect sense! Good luck!