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Some important accounting concepts lie behind the accounting policies used in the preparation of financial statements of an enterprise. One of these concepts is that the enterprise should present its accounts as a going concern; that is on the assumption that the enterprise will continue to be in operation for the foreseeable future.
Other accounting concepts are the concept of consistency in preparing financial statements from one period to another; prudence in the valuation of transactions; and the materiality concept under which transactions that are significant in relation to the financial statements as a whole, should be shown separately in the accounts, rather than being aggregated.
Another very basic accounting concept is the accrual concept. Guidance on accrued expense standards is therefore important in compiling accounts prepared using the accrual basis.
The accrual concept has an important role in selecting the accounting policies on which the financial statements of the enterprise are prepared. Under this accounting concept, the revenue and expenses are considered to have been incurred at the time when the actual transactions take place, rather than at the time that the payments are received or made. The accrual concept also lies behind the definition of the assets and liabilities that are to be recorded in the enterprise’s balance sheet at the end of the accounting period. Financial statements that are compiled using this concept are said to have been compiled on the accruals basis.
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International Accounting Standards
The International Accounting Standard IAS1, first issued in September 1997 and revised in September 2007, states that the accrual basis of accounting is to be used in preparing financial statements (except for the cash flow statement). According to IAS1, the accrual basis of accounting recognizes financial transactions or “economic events” in the accounting period to which they relate, regardless of when the actual cash transactions occur. Income is therefore matched to expenses in the period in which the economic event or transaction occurs, rather than in the period when cash or other payments are paid or received.
This concept, which is also referred to as the matching principle, is the standard practice in accounting, and ensures a more accurate picture of the company’s financial condition. This is because the income received and receivable, is matched with the expenses that have been incurred in earning that income. This approach also makes it more difficult for enterprises to influence the appearance of their financial statements in a particular period, by delaying payments to a later period.
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Examples of Accrued Expenses
Accrued expenses are therefore an integral feature of financial statements. Guidance on their treatment may be found from accrued expense standards. Accrued expenses at the end of the accounting period might include, for example, accrued salaries of employees who have worked during the last few days of the accounting period, but are not being paid until the end of the week, or month, which falls in the following accounting period. The appropriate proportion of their weekly or monthly salaries, from the previous pay day until the end of the accounting period, will therefore be included as an accrued expense.
Accrued expenses could also include interest on a loan to the enterprise which has accrued during the last part of the accounting period, where the next payment of interest is not due until a date within the following accounting period. A computation would need to be done to multiply the amount of interest accruing on a daily basis, by the number of days between the last interest payment made by the enterprise in the current accounting period, and the end of the accounting period.
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A provision is defined in the relevant international accounting standard (IAS37) as a liability of uncertain timing or amount. The accounting standard sets out the basis on which provisions are included in the financial statements for a particular accounting period. The basic principle is that a provision should only be recognized in the accounts when there is a liability. A liability is defined in the international standard as a present obligation resulting from past events. This means, effectively, that only where there is actually a genuine present obligation, can the amount be provided for in the accounts.
IAS37 states that a provision must be recognized if a present obligation has arisen as a result of a past event; that payment is probable (more likely than not); and the amount can be reliably estimated. The amount recognized in the accounts as a provision, should be the best estimate of the amount of expenditure, that would be required to meet the obligation at the balance sheet date.
Where an item of expenditure is being planned, but no actual obligation has been created before the accounting date, no provision can be included in the accounts for the period, even if that expenditure has been approved by the company’s Board of Directors. Approval of the planned expenditure within the company, for example in a resolution of the Board, does not amount to the creation of an obligation.
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Accrued expense standards require different treatment for contingencies. A contingent liability is defined in IAS37, as a possible obligation depending on whether some uncertain future event occurs; or a present obligation where payment is not probable, or the amount cannot be measured reliably. The accounting standard, states that entities should not recognize contingent liabilities in the accounts, but should disclose them, for example in a note to the financial statements, unless there is only a remote possibility that any expenditure will have to be incurred in connection with the contingency.
A typical example of a contingency might be a lawsuit, where it is quite likely that the enterprise will have to pay out a sum in damages, but the sum cannot currently be quantified with any reliability. If, on the other hand, the lawsuit is regarded by the enterprise as frivolous, and it is very unlikely that the enterprise would be required to pay any amount in damages, the contingency would not need to be disclosed in the financial statements.
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