10 MAJOR ACCOUNTING CONCEPTS

As an accounting student, you have certainly heard that accounting is the systematic process of recording, classifying, summarizing, interpreting, and communicating financial information to users of this information.

But, how do accountants record this transaction? Do they just record transactions without following assumptions? 

Of course not, they follow some assumptions. 

In today's post, we are going to be exploring a majority of these assumptions generally called accounting concepts.

Let's start with the definition of the accounting concept. 

Accounting concepts are the underlying assumptions that serve as the basis for recording business transactions and preparing final accounts.

Accountants follow at least ten basic accounting concepts including, entity concept, going concern concept, periodicity concept, money measurement concept, matching concept, realization concept, dual concept, historical concept, materiality concept and accrual concept

The Entity Concept

The entity concept recognizes business enterprises as entities separate from their owner, manager, the creditor.

In simple words, the business is distinct from its owner or anyone else. 

In other words, the entity concept state that, In preparing accounting records, the owner of a business and the business are treated as separate legal entities.

This means the personal transactions of the owners, managers must not be mixed with that of the business.

To illustrate, Sarah, the owner of a company buys a van for the delivery of goods.  This is a business transaction and therefore will be recorded in the company books. 

However, if Sarah buys a car for her personal use, that is not a business transaction, and must, therefore, not be recorded in the company books of account. 

Similarly, if the owner of a shop was to take cash from his business for settling certain personnel obligations, the account would show that the business cash had been decreased even though it does not make any difference to the owner himself.

A direct implication of this concept is that the owner's capital investment in the business is regarded as a liability of the business to the owner.

Another implication is that, for accounting purposes, a clear distinction between the owner(s)and the business is kept, even if the business is a sole proprietorship or partnership.

Going concern concept

This assumes that a business will continue to exist for an indefinite period or at least, for another twelve months.

In essence,  the business will continue to carry on activities for an indefinite period. 

Thus, financial statements should be prepared with the assumption that the business will continue to operate indefinitely unless there is evidence to the contrary.

The going concern concept is important as it formed the basis of recording assets on the balance sheet.

Accountants also charge depreciation on fixed assets given this concept. 

RECOMMENDED FOR YOU: WHAT IS AN LLC

Periodicity Concept

Also known as the period assumption or accounting period concept, states that the indefinite life of a business should be divided into periods (accounting periods) for the preparation of financial statements. 

This requires a financial statement(such as a statement of profit or loss) to be prepared at the end of every accounting period. 

A typical accounting period is usually 12 months. An accounting period may be a calendar year or fiscal year. 

A calendar year is an accounting period that begins on the 1st of January and ends on the 31st of December. 

A fiscal year, on the other hand, is an accounting period that runs through any other 12 months (except the January to December period). 

A fiscal year might run from February 1st to January 31st, or April 1st to March 31st, etc.

Monetary measurement concept

This holds that business transactions should be expressed in terms of money (which is usually the currency of the country where the financial statements are prepared).

This implies that only transactions with monetary significance are recorded.

A company, for example, that bought 100 cars would not record this in the company books since it can not be expressed in terms of money. 

Suppose the company bought the cars for €1,000,000. Then, we can record it in the company books because it is expressed in monetary terms.

It is not enough to record that the company paid salaries for July. It must include monetary figures – say, for example, N60,000 salaries expense.

Did you know why 'facts like sincerity, the commitment of employees, and the general health condition of the managing director' are not recorded in the books of the account even though they affect the company's profitability?

It's because they can not be expressed in terms of money.

The money measurement concept implies that the value of money (dollars) is assumed to be relatively stable. Hence, future changes in the value of the dollar are conveniently ignored.

Keeping view of the fact that the value of money changes, the international accounting standards committee(IASC) issued IAS 29 of financial reporting in a hyperinflationary economy. 

These accounting standards allow the financial statements of an entity with a functional currency that is hyperinflationary to be paraphrased for the changes in the general pricing power of the functional currency.

Matching Concept

The matching concept holds that revenues earned in the period the related expenses are incurred and expenses are incurred in the period the related income is earned.

The matching concept can also refer to the assigning of revenues to the accounting period in which goods were sold or services rendered and expenses incurred.

In essence, the matching concept states that all revenue for an accounting period should be matched with corresponding expenses to determine the profit (or loss) for the period concerned.

Realization Concept

The realization concept states that revenue from any business transaction should be recorded in the book of account when it is realized.

In essence, revenue is recorded only if the service is fully performed or there is evidence that revenue is earned.  

Supposed on the 15th of September, 2019, Daniel and co. received an order to supply goods worth €7,000,000.

At the end of the year, they were only able to supply goods worth €4,000,000.

The rest of the goods were supplied the following year. Then, the revenue for the year 2019 will be €4,000,000 since they weren't able to supply the €3,000,000 worth of goods that year. 

Remember that, in accounting, getting an order is not considered revenue until the goods have been delivered or payment has been received.

The Dual Aspect Concept

This principle is the primary rule in accounting. It holds that every business transaction affects two sides or has a dual aspect.

The dual concept is what is commonly known as the double-entry principle. The double principle of accounting was developed by Luca Pacioli in 1494.

The direct consequence of the dual aspect is that every transaction has the same effect on the asset and liabilities (liability and owner's equity). 

For instance, the cash an owner brought into the business (example) has two aspects which are:
A) receipt of cash
B) increase in capital.

Usually, the dual concept is illustrated in terms of the fundamental accounting equation:

ASSET=LIABILITIES + OWNER'S EQUITY

The aforementioned accounting equation states that the asset of a business is always equal to its liabilities and owner's equity.

This means that what a business owns(asset) is equal to what it owes (liabilities and owner's equity).  I have already dedicated this post to explaining this accounting equation.

Understanding dual concepts help accountants apply the relevant rules of recording business transactions.

Historical Cost

The historical cost concept of accounting states that the assets and liabilities should be recorded at cost, rather than their market value.

Historical cost is the basis upon which assets of an organization is valued, and is also the reason why assets and liabilities in the balance sheet are usually recorded at cost and not their current market values.

Materiality Concept

All accountants have to account for all financial transactions of the business regardless of the value.

However, as per the materiality concept, an accountant is advised to simply record accounting information that has material consequences on the user(s) of that statement.

The materiality(or immateriality) of a transaction will depend on its nature, value, and its importance in the decision to be taken.

Materiality requires the exercise of considerable judgment, as what is material in a small business may be immaterial in a large business.

Accrual Concept

The accrual concept states that revenues are recognized when they are earned(regardless of when received) and expenses are recognized when there are incurred(regardless of when paid).

It stipulates that revenue should be recognized when it is earned.

What does this mean?

Income is different from cash collection and expense is different from cash payments.

Under the accrual basis, revenues and expenses are recognized when they occurred regardless of when the amounts are received or paid.

For example, Daniel offers laundry services to a client on October 9, 2012. The client paid on January 12, 2013. The revenue will be recognized on October 9, 2012, not January 12, 2013.

We just learned accounting concepts. Now, let's quickly practice these two questions.

1. Ten years ago, my company bought equipment for €1,000,000. The values of the equipment have since risen.

A valuator told me that the equipment is worth €2,000,000. Since the equipment is now worth €2,000,000, I am pondering on increasing its value in the books of account so it could reflect the current market value. Should I do so?

2. As the owner of a business, I think the company's most valuable asset is my employee. 

This is because the service provided by my company hinges largely on my employee's ability to do their job effectively. 

I am ruminating on including the value of my employee dedication, and honesty in the balance. 

As a diligent accountant, would you advise me to include it in the company books?

Answer

1. No, the equipment should not be recorded at its current market value of €2,000,000, rather, it should still be recorded as €1,000,000. This highlights the historical cost concept.

2. No, I wouldn't advise you to do so. Doing so will contravene the Monetary measurement concept. The reason is that employee dedication, integrity can not be expressed in terms of monetary value(or euros). 

We will apply these rules when we begin to debit and credit business transactions.

In this post about journal entries, we also apply this assumption, you can check it out here.

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