Accounting Concepts

Accounting involves the processing and summarizing of considerable volumes of information by many
individuals working for a variety of organisations, each with their own special needs and interests. As a
result you can imagine that there could be scope for financial records to be distorted or even manipulated. To
ensure that accounting statements are prepared in the same way, whatever the situation, there are a set of
rules, often referred to as accounting concepts and conventions (and sometimes as accounting
principles), which ensure that users can have confidence in the information with which they are provided.

1. The dual aspect concept

This states that there are two aspects of accounting, one represented by the assets of a business and the other
by the claims against them. The concept states that that these two aspects are always equal to each other. In
other words:

ASSETS = CAPITAL + LIABILITIES

Double entry is the name given to the method of recording the transactions for the duel aspect concept.

2. The historical cost concept

It means that assets are normally shown at cost price and this is the basis for the valuation of the asset.

3. Business entity concept (separate entity concept)

This concept implies that the affairs of a business are to be treated as being quite separate from the personal
activities of its owner(s).

The items recorded in the books of the business, are, therefore, restricted to the transactions of the business.
No matter what activities the proprietor(s) are involved in outside the business, they are disregarded in the
books kept by the business.

The only time the personal resources of the proprietor(s) affect the firm’s accounting records is when they
introduce new capital into the business or take drawings from it.

4. Going concern concept

This concept implies that the business will continue to operate for the foreseeable future. In other words, it is
assumed that the business will continue for a long period of time. Therefore, when the financial statements
are prepared, that is, the trading and profit and loss account (income statement) and statement of
financial position (balance sheet), it is assumed there is no intention of the business reducing in size or
indeed ceasing to trade in the future. Consequently, the assets would be valued using the historical cost
concept.
However, when a business ceases to trade as a going concern or the owners decide to sell the business or
perhaps the business goes into liquidation, then the value of the assets can be quite different. In these,
circumstances the saleable value of the assets would be used in the financial statements, that is, the reduced
value of the non-current assets (fixed assets) instead of their cost.

5. Consistency
Even if we do everything already listed under concepts and conventions, there will still be quite a few
different ways in which items could be recorded. Each business should try to choose the methods that give
the most reliable picture of the business.

This cannot be done if one method is used in one year and another method in the next year, and so on.
Constantly changing the methods, would lead to misleading profits being calculated from the accounting
records. This conventions says that when a business has fixed a method for the accounting treatment of an
item, it will enter all similar items in exactly the same way when preparing the financial statements in
following years. Examples of when the consistency concept is used include:
▪ Methods of depreciation
▪ Inventory valuation

However, it does not mean that the business has to follow the method until the firm closes down. A business
can change the method used, but such a change is not taken without due consideration. When such a change
occurs and the profits calculated in that year are affected by a material amount, either in the profit and loss
account itself or in one of the reports with it, the effect of the change should be stated.

6. Realisation
This concept holds the view that profit can only be taken into account when realisation has occurred – in
other words, until it is reasonably certain of being earned. Profit is normally said to be earned when:
• goods or services are provided to the buyer
• the buyer accepts liability to pay for the goods or services
• the monetary value of the goods or services has been established
• the buyer will be in a situation to be able to pay for the goods or services.

Notice that it is not the time:

• when the order is received, or
• when the customer pays for the goods.

However, it is only when you can be reasonably certain as to how much will be received that you can
recognise profits or gains.
 7. The accrual concept or matching concept
The concept says that net profit is the difference between revenues and expenses incurred in generating those
revenues, namely
REVENUES – EXPENSES = NET PROFIT
Determining the expenses used up to obtain the revenues is referred to as matching expenses against
revenues; that is why this concept is also called the matching concept. The key to the application of the
concept is that all income and charges relating to the financial period to which the financial statements relate
should be taken into account without regard to the date of the receipt or payment.

Sales are revenues when the goods are sold and not when the money is received, which can be in a later
period. Purchases are expenses when goods are bought, not when they are paid for. As we shall see in a later
chapter, items such as rent, insurance, motor expenses and so on are treated as expenses when they are
incurred, not when they are paid for. Adjustments are made when preparing financial statements for expenses
owing and those paid in advance.

By showing the actual expenses ‘incurred’ in a period matched against revenues earned in the same period, a
correct figure of net profit will be shown in the profit and loss account (income statement).

8. Prudence
Very often accountants have to use their judgement to decide which figure they will take for an item.
Suppose a debt has been outstanding for quite a long time and no one knows whether it will be paid. Should
the accountant be an optimist in thinking that it will be paid, or be more pessimistic?

It is the accountant’s duty to see that people get the proper facts about a business. They should make certain
that assets are not overvalued and similarly that liabilities should not be shown at values too low. Otherwise,
people might ill-advisedly lend money to a firm, which they would not do had the proper facts been known.

The accountant should always be on the side of caution; this is known as prudence. The prudence convention
means that, normally, accountants will take the figure that will understate rather than overstate the profit.
Thus, they should choose the figure that will cause the capital of the firm to be shown at a lower amount
rather than at a higher one. They will also normally make sure that all losses are recorded in the books, but
profits should not be anticipated by recording them before they are realised.

9. The money measurement concept

Accounting is concerned only with these facts:
• it can be measured in money, and
• most people will agree to the ‘monetary’ value of the transaction.

This means that accounting can never tell you everything about a business. For example, accounting does not
show the following:
i. whether the firm has good or bad managers
ii. whether there are serious problems with the workforce
 iii. whether a rival product is about to take away many of its best customers
iv. whether the government is about to pass a law that will cost the business extra expense in future.

The reason that (i) to (iv) above, or similar items, are not recorded is that it would be impossible to work out
a money value for them that most people would agree to. Some people think that accounting tells you
everything you want to know, but the above shows that this is not true.

10. Substance over form

This concept is a requirement of Financial Reporting Standard FRS 5. The legal form of a transaction can
differ from its real substance. Where this happens, accounting should show the transaction in accordance
with its real substance, which is basically how the transaction affects the economic situation of the firm. This
means that accounting, in this instance, will not reflect the exact legal position concerning that transaction.
An example would be when a business rented a car under a lease that allowed it to purchase the car at the
end of three years for $10. The substance of the agreement is hire purchase, but the form is rental. It should
be treated as if it were a hire purchase.

11. Materiality
If an item is relatively small in value, the concept of materiality applies and as such the item does not need
separate recording. For example, the purchase of a box of paperclips, a waste paper bin or calculator for the
office. These small items are regarded as ‘not material’ and would be recorded in a general expense account
such as ‘sundry expenses account’ whereas a non-current asset, such as a motor vehicle or plant and
machinery, would be classified as ‘capital expenditure’