Ethical rules

Ethical rules can be considered as moral code or principles expected to be adopted in the preparation of accounts.

There are four rules, as described below.

Prudence

Prudence rules that the revenues recognised should not be overestimated, nor the amount of expenses underestimated. Also, the accountant should be conservative when recording the amount of assets, and not underestimate liabilities. The result should be conservatively stated in the financial statements.

Prudence should normally be used in situations such as an allowance for doubtful accounts or a reserve for obsolete inventory. In both cases, a specific item that will cause an expense has not yet been identified, but prudence would record a reserve in anticipation of a reasonable amount of these expenses arising at some point in the future.

Consistency

Consistency in accounting states that once an accountant adopts an accounting principle or approach, they should continue to follow it consistently in future accounting periods.

The accounting principle or approach should only be changed if a newer version could in some way enhance the results of the financial report. If such changes are made, the effect should be documented and incorporated with a note accompanying the financial statements.

Objectivity

Objectivity is the concept that an organisation’s financial statements should be based on solid evidence. The aim behind this rule is to keep the management and the accounting unit of an entity from producing financial statements that are one-sided by the opinions and biases of the company.

Relevance

Relevance is the concept that the information generated by an accounting system should impact the decision-making of someone perusing the information.

The concept can refer to the content of the information and/or its timeliness, both of which can impact decision-making. In particular, information that is provided to users more quickly is considered to have an increased level of relevance.

This impact may simply be to confirm a decision that the reader has already made (such as to retain an investment in a company) or to reach a new decision (such as to sell an investment in a company).

For example, suppose a company is thinking of buying another firm. If it is revealed that the target firm has a previous undocumented and material liability, this is relevant to the decision of the acquirer in regard to whether it should extend an offer to buy the target firm, and the price it is willing to pay.

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This article is from the free online course:

An Introduction to Financial Management in Construction

Coventry University