07/02/2023
Accounting concepts
By Abel Lungu
Accounting concepts are the basic assumptions and rules and principles which work as the basis of recording of business transactions and preparing accounts.
These are also known as Accounting Conventions. A convention is a usual or accepted way of behaving, especially in social situations, often following an old way of thinking or a custom in one particular society. So, accountants also sat down and agreed on what must be the accepted thinking and behaviour when preparing financial statements. The key concepts are discussed below.
• Cost Concept: The cost concept of accounting states that all acquisitions of items (e.g., assets or items needed for expending) should be recorded and retained in books at cost. Cost is all expenditure incurred to bring an item to its present location and condition.
• Prudence Concept: Revenue is only recognised when there is a reasonable certainty that it will be realised, whereas expenses are recognised sooner, when there is a reasonable possibility that they will be incurred. This concept tends to result in more conservative financial statements which accelerate bad news but delay good news!
• Going Concern: Financial statements are prepared on the assumption that the business will remain in operation in future periods. Under this assumption, revenue and expense recognition may be deferred to a future period, when the company is still operating. If the assumption of going concern is not there, all expense recognition in particular would be accelerated into the current period, and assets would be stated at lower values as if you want to sell them quickly (break-up value).
• Business Entity Concept: The transactions of a business are to be kept separate from those of its owners. By doing so, there is no mixing of personal and business transactions in a company's financial statements.
• Realisation Concept: Revenue can only be recognised once the underlying goods or services associated with the revenue have been delivered or rendered, respectively. Thus, revenue can only be recognised after it has been earned. So, if you receive a payment in advance from a customer, you will not recognise the receipt as revenue until you fulfill your obligation to that customer. Meanwhile, you will show the received funds as a liability.
• Objectivity Concept: Financial information should be unbiased and free from any kind of internal and external influence.
• Dual Aspect: This concept explains that if something is given, someone will receive it. This can be explained as whenever a transaction occurs, there is a two-sided effect; one is credit (negative), and the other is debit (positive) for a similar amount.
• Consistence: Once a business chooses to use a specific accounting method, it should continue using it on a go-forward basis. By doing so, financial statements prepared in multiple periods can be reliably compared.
• Accrual: The effects of transactions and other events are recognised when they occur (and not as cash is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. For example, if we have rented a building for a period of 12 months, from January to December, which period also happens to be our financial year, but we have not paid the landlord for the last three months (October to December), we will still show the whole 12 months’ rent as an expense in the financial statements, although we only paid for nine months. We will show the arrears of three months as a liability.
• Materiality: Transactions should be recorded when not doing so might alter the decisions made by a reader of a company's financial statements. This tends to result in relatively small-size transactions being recorded, so that the financial statements comprehensively represent the financial results, financial position, and cash flows of a business.
• Matching Concept (Periodical Concept): The expenses related to revenue should be recognised in the same period in which the revenue was recognised. By doing this, there is no deferral of expense recognition into later reporting periods, so that someone viewing a company's financial statements can be assured that all aspects of a transaction have been recorded at the same time.
The author is a Chartered Certified Accountant with over 20 years of experience in industry and academia.
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