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Accounting Concepts

Accounting equation concept

The total assets of a firm are equal to the capital or the owners’ equity plus total liabilities. Any transaction will affect both sides of the equation, equally in terms of monetary value. For example, a business owner introduces a sum of money into the business as additional capital. This action increases the capital side of the equation and at the same time increases the opposing asset side as the introduced amount increases the current asset of cash.


Accounting period concept

Regardless of how long a business will continue to be in operation, periodic statements must be prepared to show the profitability or otherwise of the business operation. Commonly, a twelve-month period is used to determine the profitability or loss. At the end of this accounting period a profit and loss account and balance sheet are prepared. The profit and loss statement shows the profit or loss made by the business in that period while the balance sheet shows the financial position of the business as at the end of the period.


Accruals concept

Revenue and expenses are reported in the period in which they occur and not when cash is received or paid out.


Business entity concept

When the owner of a business is engaged in non-business activities, these activities are treated as separate from those financial activities of the business. Recording done in the company’s books must therefore show only the transactions of the business. However, it is not a separate issue when the owner introduces additional capital to the business or makes withdrawals from it.


Consistency concept

Once an accounting method is adopted for treating an item, it should be used to treat all similar items. The method should continue to be used over different accounting periods. If constantly changing the methods by using one for one period and another for another period, wild fluctuations in periodic profits can be expected. However, the method can be changed but only with justifiable reason. Change in the method must be disclosed.


Cost basis concept

On the balance sheet an asset is recorded at its original cost at the time the asset was acquired. The value of the asset may have changed significantly over the years but this is not taken into consideration. For example, an asset of land acquired ten years ago has increased five-fold in its market value from $200,000 to $1,000,000. On the balance sheet the land is still shown at $200,000 and its actual market value is recognized only when it is sold.

Not all assets however are shown at historical cost. One exception is the marketable securities which are recorded at their market value on the balance sheet.


Dual aspect concept

This is represented by the accounting equation On one side are assets while on the other are the capital and liabilities. Each transaction is recorded as a double-entry with each entry on either side so that the two sides are always equal to each other.


Full disclosure concept

Financial statements are required to provide the necessary information that will assist interested parties to make informed decisions about the business. This concept is related to the materiality concept in that it requires the full disclosure of information and events deemed significant so that users of the information are not misled. Unimportant and trivial matters that do not have an adverse effect on the financial statements are not disclosed.

Examples of events that need to be disclosed are changes in accounting methods which differ from those used in the previous periods, pending litigation, and a big fire that destroyed a large portion of the factory. Non-disclosure of such an event is likely to cause the financial statement to be misleading. There are groups of people such as owners, investors, lenders, creditors, suppliers, bankers, government officials and others who make use of the information to arrive at decisions for various reasons. The financial statements must therefore be prepared with full disclosure of material information about the performance of the business for the benefits of these people.


Going concern concept

The business is not assumed to be in imminent danger of closing down and will continue to operate. It is therefore necessary to maintain the valuations of assets using the cost concept. The going concern concept is not used if the company is faced with the prospect of closing down.


Lower of cost or market value concept

Inventory is value either at cost or the market value whichever is lower. Under this concept, market cannot exceed the ceiling (net realizable value = selling price less costs to complete and dispose) nor can market be less than the floor (net realizable value less normal profit margin).


Maintenance of capital

Under this concept, capital is synonymous with the net assets or equity of the business. The capital of the business is only maintained if the money value of its net assets at the end of a financial year is equal to or exceeds the money value of its net assets at the beginning of the year. This excludes any introduction of additional capital or cash withdrawals by the owners.


Matching concept

Revenues and expenses are recorded in the period to which they belong. The reason for this is the expenses are recognized as being used in a particular period to obtain revenue for the same period. Expenses are thus matched against revenue.


Materiality concept

What constitute material are those items that are important and significant enough to matter. Small matters that are unimportant or insignificant are disregarded as their non-disclosure does not have a serious effect on the accuracy of the financial statements. Only items that are considered significant are disclosed.

There is no hard and fast rule governing what is material and what is not. Materiality is determined within individual business organizations. How an event or item is judged to be significant or material is dependent on the rules set by individual firms. What is material to one firm may not be material to another. For example, an item of equipment costing $500 is a material item to a small business but not so to a large business organization. A couple of CD racks for office use are likely to last for at least two or three financial years but are not treated as material items and therefore charged as expense items in the financial year they were bought.

The correct approach is to be concerned with matters that are significant, and not with those that are not. By not omitting unimportant items where they should be omitted may well overload a statement such as an income statement. This may lead to confusion to those making use of the statement. On the other hand, where material matters are overlooked they may distort the facts presented causing wrong decisions to be made interested parties. Omission and misstatement should therefore be avoided in accounting reports.


Money measurement concept

Only the transactions that can be expressed in monetary terms are recorded. People will find it a lot easier to agree to the value of a transaction if it is measurable in money. Things that cannot have a money value placed on them are not possible to be recorded in accounting books as recording requires a common unit of measurement and only money can fulfil this role.

On the balance sheet is found a variety of disparate items which are not able to be compared. A common unit of measurement is therefore necessary to for example compare current assets to current liabilities, show the value of the assets in relation to the capital, determine the profitability or otherwise of the company, etc. Things which cannot be expressed in terms of money are not shown on the balance sheet. For example, the efficiency of the workforce or the competence of the management, the money value of which is quite impossible to calculate is not shown on the balance sheet.

Objectivity concept

All recorded information must be obtained from objective sources such as source documents, examples of which are invoices, delivery notes, receipts, bank statements, and physical counts such as those conducted over inventory items. This makes the entries in the books reliable, indisputable and verifiable. For example, assets valued at cost are beyond dispute as their costs are based on their purchase prices. There are however entries in accounts which have no objective evidence to base on such as making provisions for depreciation and bad debts. The figures arrived at may be subjective but the most objective evidence such as past statistics should be used for reference so that the figures are sufficiently reliable.

Prudence concept

Valuation of assets should be carried out with moderation so that the value is not increased by too high an amount. Liabilities should not be understated otherwise external parties are misled into believing the viability of the company and will continue or want to conduct business with it. An amount that is too long in owing is very likely to be a bad debt and this has to be taken in consideration. If two possible figures are arrived for an item, say capital, it’s always prudent to choose the lowest amount.

Realization concept

The assets and liabilities may not reflect their actual market value due to changes in market conditions. The increase or decrease in their values does not affect the profit or loss of the business unless they are disposed of or paid off. Even when payments are received for sales, realization has not occurred until it is certain that no goods sold will be returned. Profit can only be recognized when realization has taken place.

Substance over form concept

In accounting, the real substance of a transaction differs from its legal form. The transaction is shown based on the accounting view to reflect the financial state of the business rather than from the legal point of view. This accounting principle ensures that financial statements give a complete, relevant and accurate representation of transactions. An example is the acquisition of a van on hire-purchase agreement by a company. From the legal point of view, the company gains ownership of the vehicle only when all the hire-purchase instalments have been paid. But in the company’s financial record, the company is shown as owner of the van as well as the amount still owed on the hire-purchase.

Historical cost convention

This convention requires the historical cost of the asset to be shown on the balance sheet. The historical cost is the original price of the asset that the buyer paid, and this is an objective valuation of the asset. No consideration is given to the changing market value of the asset during the period it is owned by a business. Neither is it given to high inflation which affects the historical cost. An exception of an asset that does not come under this convention is marketable securities which are recorded according to their market value.


Unit of measurement convention

Financial recording in accounting books is done with a common unit of measurement using a currency. For example, in the United States the unit of measurement concept requires recording of all economic data to be in dollars. Transactions and activities of a business have to have a common unit of measure so that they can be measured, compared and reported and the common unit is money.

Last Updated (Tuesday, 09 November 2010 18:17)