Accounting concepts

Accounting principles are sometimes referred to as concepts and conventions.

 A concept is a rule which sets down how the financial activities of a business are recorded.
 A convention is an acceptable method by which the rule is applied to a given situation.
 Some of the main accounting principles have already been applied to the practical accounting
examples in the previous chapters.
Below are the main accounting principles
Business Entity
 This is also known as the accounting entity principle. This means that the business is treated
as being completely separate from the owner of the business.
 The personal assets of the owner, the personal spending of the owner etc. do not appear in the
accounting records of the business.
 The accounting records relate only to the business and record the assets of the business, the
liabilities of the business, the money spent by the business and so on.
 Everything is recorded from the viewpoint of the business. If there is a transaction
concerning both the business and its owner then it is recorded in the accounting records of
the business.
 When the owner introduces capital into the business, it is credited to the capital
account (to show the funds coming from the owner).
 The capital account shows a credit balance representing the amount owed by the business to
the owner. When the owner makes drawings from the business a debit entry will be made in
the drawings account (to show the value going to the owner) which reduces the amount owed
by the business to the owner.
 The practical application of the principle of accounting entity has already been explained in
the chapters on double entry bookkeeping and financial statements.

Duality
 This is also referred to as the dual aspect principle. It has been explained in previous chapters
how every transaction has two aspects – a giving and a receiving.
 The term double entry is used to describe how these two aspects of a transaction are recorded
in the accounting records.

Money measurement
 This accounting principle means that only information which can be expressed in terms of
money can be recorded in the accounting records.
 Money is a recognised unit of measure and is a traditional way of valuing transactions. It
does not rely on personal opinions and it is factual.
 There are many aspects of a business which cannot be measured in terms of money and,
therefore, do not appear in the accounting records.
 The morale of the workforce, the effectiveness of a good manager, the benefits of a staff
training course all play an important part in the success of the business, but they will not
appear in the accounting records as their value cannot be expressed in monetary terms.
 In a similar way, the launch of a rival product or increased competition cannot be recorded in
the accounting records as their effects cannot be measured in monetary terms.

Realisation
 This principle emphasises the importance of not recording a profit until it has actually been
earned.
 This means that profit is only regarded as being earned when the legal title to goods or
services passes from the seller to the buyer, who has then an obligation (liability) to pay for
those goods.
 When an order is placed by a customer no goods change hands, and no profit is earned. Profit
is regarded as being realised when the goods actually change hands.
 This is the same even if the goods are sold on credit and the customer does not pay for them
immediately.

Consistency
 There are some areas of accounting where a choice of method is available.
 For example, there are several different ways to calculate the depreciation of a non-current
asset.
 Where a choice of method is available, the one with the most realistic outcome should be
selected.
 Once a method has been selected, the method must be used consistently from one accounting
period to the next.
 If this is not done, a comparison of the financial results from year to year is impossible, and
the profit of a particular year can be distorted. There may be a good reason why it is
necessary to change a method or valuation.
 In such a situation, the charge may be made, but the effects of this should be noted in the
financial statements.

Accruals
 This is also referred to as the matching principle. This is an extension of the realisation
principle. As explained earlier, profit is earned when the ownership of goods passes to the
customer, not when the goods are actually paid for.
 The accruals principle extends this beyond the purchase and sale of goods to include other
income and expenses.
 The revenue of the accounting period is matched against the costs of the same period (the
timing of the actual receipts and payments is ignored).
 The figures shown in an income statement must relate to the period of time covered by that
statement, whether or not any money has changed hands.
 This means that a more meaningful comparison can be made of the profits, sales, expenses
and so on from year to year.
 The accruals principle is also applied to capital and revenue expenditure.

Prudence
 This is also known as the principle of conservatism. This principle ensures that the
accounting records present a realistic picture of the position of the business.
 Accountants should ensure that profits and assets are not overstated and that liabilities are not
understated. The phrase “never anticipate a profit, but provide for all possible losses” is often
used to describe the principle of prudence.
 Profit should only be recognised when it is reasonably certain that such a profit has been
realised and all possible losses should be provided for.
 We have already learned why it is necessary to provide for the loss in value of non-current
assets as well as making provisions for customers who do not settle their accounts.
 If this is not done, the value of such assets will be overstated in the balance sheet.
 Prudence is a very important principle. If a situation arises where applying another
accounting principle would be contrary to the principle of prudence, then the principle of
prudence is applied (this principle overrules all the other principles).
 For example, under the realisation principle, profit is earned when goods actually change
hands; but if the customer fails to pay after a reasonable time, the principle of prudence may
be applied and the debt is written off.

Going concern
 The accounting records of a business are always maintained on the basis of assumed
continuity. This means that it is assumed that the business will continue to operate for an
indefinite period of time and that there is no intention to close down the business or reduce
the size of the business by any significant amount.
 This continuity means that the non-current assets shown in a balance sheet will appear at
their book value, which is the original cost less depreciation, and inventory will appear at the
lower of cost
or net realisable value.
 If it is expected that the business will cease to operate in the near future the asset values in
the balance sheet will be adjusted. Assets will be shown at their expected sale values which
are more meaningful than their book value in this situation.

Materiality
 This principle applies to items of very low value (items which are not “material”) which are
not worth recording as separate items.
 Other principles can be ignored if the time and cost involved in recording such low value
items far outweigh any benefits to be gained from the strict application of these principles.
For example, a pocket calculator purchased for office use is strictly a non-current asset, part
of its value being “lost” each year through normal usage.
 The cost of calculating and recording this each year would amount to more than the cost of
the asset. Instead of the calculator being recorded as a non-current asset, it would be regarded
as an office expense in the year of purchase.
 What is material for one business may not be so for another business. A lap top computer
may be regarded as immaterial for a large multi-national business, but would be material for
a
small sole trader.
 A large business may decide that non-current assets costing less than $1000 will be regarded
as immaterial and be charged as expenses.
 A small business may have a much lower figure.
 This principle is also applied by entering small expenses in one account known as “general
expenses” or “sundry expenses” rather than having individual ledger accounts for office
expenses like light bulbs, flower displays etc.
 Materiality is also applied in relation to inventories of office supplies like envelopes when
the total cost of envelopes purchased during the year is treated as an expense even though
there are some left at the end of the year.

Historical cost
 This principle requires that all assets and expenses are recorded in the ledger accounts at their
actual cost. It is closely linked to the money measurement principle.
 Cost is a known fact and can be verified. Applying this principle makes it difficult to make
comparisons about transactions occurring at different times because of the effect of inflation.
Sometimes it is necessary to adopt a more prudent approach to ensure that the non-current
assets are shown at a more realistic value, so the cost price is reduced by depreciation.

Accounting period
 The principle of going concern assumes that a business will continue to operate for an
indefinite period of time.
 It is clearly not sensible or practical to wait until a business ceases trading before a report on
its progress is made.
 Because reports are required at regular intervals, the life of the business is divided into
accounting periods – usually years.
 This allows meaningful comparisons to be made between different periods for the same
business and between one business and another business.
 Financial statements are prepared for each time period and transactions are regarded as
occurring in either one period or another.
 The practical application of this has been shown in earlier chapters when the balance of a
ledger account at the end of one trading period was carried down to become the opening
balance of the next accounting period. It was also shown when the expenses for the period
were totalled and transferred to the income statement for the period.