The Accruals and Going Concern Concepts Are Regarded as Fundamental in the Preparation of Financial Statements. Discuss the Advantages and Disadvantages of These Concepts, Explaining Why They May Be Difficult to Apply.

The accruals and going concern concepts are regarded as fundamental in the preparation of financial statements. Discuss the advantages and disadvantages of these concepts, explaining why they may be difficult to apply.

Two financial statements that are regarded as fundamental in the preparation of financial statements are the accruals and going concern concepts. The accruals concept outlines that income and expenses should be recognised in the accounting period in which it occurs, rather than recognised when cash has been received or paid out (Benedict & Elliott, 2011, pp. 141-142). Usually, this means that transactions occur when expenses were used by the entity or when the income has actually been earned, rather than when cash has been paid as expenses, or received from sales (Thomas & Ward, 2012, p. 67).

The going concern concept assumes that the entity at hand will continue to operate and not fall into liquidation within the foreseeable future (Thomas & Ward, 2012, p. 66). “[..] financial statements are prepared on a going concern basis, unless management either intends to liquidate the entity [..,]cease operations, or has no realistic alternative but to do so.” (Financial Reporting Council, 2014, p. 5).

Both of the aforementioned accounting concepts have their advantages and disadvantages. They also may be difficult to apply. These areas shall be discussed.

In terms of the accruals concept, it’s advantages include being superior to cash accounting, for the vast majority of firms. Cash accounting is the basis that one debits or credits money to accounts as cash is received or paid out. This method is not allowed in the UK for published accounts (Law & Owen, 2010), which in its own right implies an advantage of the accruals concept, as its adequacy is regarded as higher than its comparative concept.

An advantage of the accruals concept, compared to cash accounting is that “the cash basis is misleading on a yearly basis and even more misleading when monthly operating statements are prepared.” (Stone, 1965). This is supported by Dr Carolyn Cordery, who argues that cash accounting seldom illustrates a clear presentation of an entity’s financial health (Cordery, 2010, pp. 58-59). Therefore, accruals is a clearer form of accounting. One reason being because, firm’s payments cannot be delayed and then shown in the next accounting period, consequently appearing more profitable than the firm actually is (Benedict & Elliott, 2011, p. 142). Therefore, the advantage being that it avoids the ability to deceive stakeholders in terms of profit, compared to cash accounting.

On the other hand, the accruals concept can also possess disadvantages.  For example, accruals accounting is harder to apply, ergo needing (potentially more) employees who have sufficient financial skills (such as being able to use double entry) to employ the accruals concept (Hyndman & Connolly, 2011, p. 42). For example, whilst applying the accruals concept, estimation has to be applied to aspects such as inventory, which requires added skill. Accruals requires opening and closing stock to be accounted for in the gross profit calculation, thus having to estimate the value of stock. This would not have to be done in cash accounting (Britton & Waterston, 2009, pp. 61-62). This is one argument stating why the accruals concept can be seen as difficult to apply.

Consequently, an entity wishing to use this concept would have the added cost of paying someone with financial competence (typically hiring an accountant), thus also more expensive to apply the concept. This could be seen in the instance of a small start-up firm, where the proprietor may possess no financial or accounting expertise, ergo having to employ someone that does.

Another fundamental accounting concept is going concern. An advantage of this concept is that, similar to the accruals concept, the entity has to portray their financial position truthfully, as they have to disclose whether they believe they are a going concern or not. This is an International Accounting Standards requirement (Thomas & Ward, 2012, p. 67). In turn, potential investors are aware whether the entity are at risk of failing in the foreseeable future, thus can base investment decisions on this fact. Research conducted into this concept concluded that, “when investors, informed by the GC [‘Going Concern’] opinion, believe a company will go bankrupt, they act to protect their interests by demanding a greater rate of return.”, ergo increasing the cost of equity to the business (Amin, et al., 2014). This is a persuasive argument, outlining the going concern’s advantages, as research has shown that investor decisions have benefitted by the concept, thus reducing their risk of investment via demanding higher returns from higher risk ventures.

Alternatively, the going concern may also have disadvantages, including difficulty of application. Auditors are required to make an assessment of businesses, including whether they are a going concern or not (Financial Reporting Council, 2014, p. 3). Ethical issues can arise with auditing, whether the auditor publishes a ‘clean opinion’, which shows that financial statements give an accurate representation of the business (Investopedia, 2015), or a ‘going-concern opinion’. This opinion shows doubt that the entity will be a going concern (Times, 2015). This fact may be able to refute the aforementioned advantage of the going concern concept.