“I skipped that chapter in the textbook as it was all words.”
“I just need to know how to do it not why.”
Have you ever made a statement like either of these? I’ve heard them repeatedly over my years as an AAT tutor, especially when we reach the theoretical part of the syllabus. But I’m passionate about the fact that in order to be competent accounting technicians, we need to understand why we do what we do.
In fact, I believe there’s too much to remember when it comes to accounts, so the only way to be successful is to understand what you’re doing and use the theory to work out the practical application.
The accruals or matching concept
The accruals or matching concept is a classic example as so many students find it hard to understand. The theory is:
Matching income generated with expenses incurred, to a financial period, regardless of when the money is paid or received.
But what does it mean in practice?
Let’s split it up into three sections:
Theory: Matching expenditure incurred with income generated
Practice: We match up the accounts on the Statement of profit or loss (SPL). We can only include ‘Expenses’ in the bottom half that have been spent to generate the ‘Net Sales’ at the top.
Theory: To a financial period
Practice: The figures on our financial statements have to be for the accounting period i.e. month, quarter or year.
Theory: Regardless of when the money is paid or received.
Practice: The banking date of a transaction does not matter, other than to indicate if it is in the right period or requires adjusting.
The accruals concept is responsible for the majority of year-end adjustments:
We adjust the inventory on the SPL as we can’t match what is left in the stock room at year-end to this year’s sales because we haven’t sold it.
Therefore it’s deducted as closing inventory at year-end and added on as opening inventory the next year. We’ve matched the expense to the year it generated sales income.
We’ve probably already paid for it but that doesn’t matter.
If we buy machinery that will manufacture products for us for five years, we’ll be able to generate five years’ worth of sales income from the acquisition.
If we pay for the machinery after 30 days, the full cost of the expense is deducted from our bank account in the first financial year. One year’s worth of expense does not match five years’ worth of income.
Therefore, we split the capital expenditure up into five depreciation charges and match one a year for the five years we expect to generate income.
Again it doesn’t matter that the original invoice was paid in full during the first year.
Adjustments for Pre-payments and Accruals
The fact that one of our practical year-end adjustments has the same name as the theory is confusing. However, like all the other examples above, the reason we make adjustments for prepayments and accruals is because of the concept.
For example, when we pre-pay an expense there is a mis-match between the financial period and the invoice period. The financial period will end before the invoice period so we’ll need to reduce this year’s expense and increase next year’s to match them correctly.
As ever the expense’s payment date is only relevant in so far as it enables us to see when the funds changed hands.
Accruals and depreciation
The accruals concept is a fundamental theory that underpins modern accounting but it’s by no means the only one and does not work in isolation.
Whilst we adjust our SPL for inventory to comply with the accruals concept we value it according to IAS 2, which states that inventories should be valued at the lower of cost or net realisable value. Deprecation is also governed by IAS 16, which gives guidelines for the appropriate selection of methods and rates.
Whilst IASs (International Accounting Standards) are part of the practical system of rules, the accruals concept is part of the Conceptual Framework for Financial Reporting along with going concern and materiality.
The going concern theory
The going concern theory assumes ‘that a business will continue to trade for the foreseeable future’. Imagine we are considering running our own business. We could either start from scratch or buy a ‘going concern’ that is already trading. If we consider an existing business we need to see that it’s financially viable as we’ll be buying its assets and taking on its liabilities.
The going concern concept ensures that accounts are prepared to accurately reflect the viability of businesses.
The concept of materiality deems that ‘information is material if omitting, misstating or obscuring it could be reasonably expected to influence decisions that the primary users of the general purpose reports make on the basis of those reports.’ However, it is applied differently to different organisations and items. For example, a large building firm and sole trader might both spend £500 on a drill. It is the same item and has the same value to both businesses. However, the concept of materiality means that the purchases can be treated differently. Within the large firm it might not be deemed an expensive or irregular purchase, whereas for the self-employed builder, it could be one off capital expenditure on an asset that will be retained for a number of years. The large firm could decide to write off the purchase as revenue as opposed to capital expenditure, as the value is immaterial to it, whereas the sole trader could treat it as an asset, showing it on the SoFP and deprecating its value accordingly because, in this context, it is material.
The accounting equation
Finally, we need to think about the accounting equation. It’s fundamental to how accounting systems and double-entry bookkeeping work but often overlooked once we get into the practical swing of accounting.
Assets – Liabilities = Capital
what we own less what we owe leaves what the business is worth and therefore owes the owner(s).
Being able to categorise accounts into their basic types and know how to increase and decrease them is the key to understanding how the theory of the equation is affected by different transactions.
You may not like it, but the reality is that if you work in accounts then you are using accounting theory on a regular basis. And if you understand the theory it can’t fail to improve your practical skills.
Read more study tips on AAT Comment:
- Study tips: Accruals concepts part 1
- What to expect from Advanced level AAT
- Study tips: Cost of goods sold
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.