A1 Accounting Concepts
Accounting concepts are the basic rules and principles that firms should follow when preparing their financial statements. The most widely used set of accounting principles are the International Financial Reporting Standards (IFRS). The overall purpose is to ensure that the financial statements produced by each company give a clear and accurate picture of their financial position. This means that they can be interpreted by external parties.
Materiality refers to the significance of individual transactions of a business in their financial statements. Transactions that will not have an impact on decisions made by those viewing statements should be excluded and those which would have an impact on decisions should be included.
A furniture company may buy a new broom to sweep the warehouse. This would technically be a company asset but would not have an impact on the decisions made by those consulting financial statements. If the same company made a purchase of a new piece of machinery that made production more efficient, that would be of interest due to its cost and impact on company performance. The machinery would be recorded as an asset and the broom an expense.
Realisation is the principle that revenue should be recorded on financial statements when the money is earned rather than when the cash is received. A company can reasonably expect a customer to pay once the goods have been delivered and an invoice has been issued.
A going concern is a business that is financially stable enough to keep operating for the foreseeable future. They have the assets and liquidity to meet their current and future obligations.
A business entity is a separate entity from the owner of the business. This means that the financial records of the business must be kept separate from the personal finances of the owner.
The duality concept requires all financial transactions to be recorded in two places. This allows the accounts to show the movement of funds. For example, when a business purchases an item, they will debit their cash account but credit their assets account.
Consistency means that businesses must use the same methods of processing and recording financial statements from one period to the next. For example, if they alter the value of their non-current assets using the straight-line method of depreciation one year, they cannot switch to the reducing balance method the following year.
Historical cost is the amount of money originally spent on the acquisition of an asset. The historical cost principle requires businesses to record the historical cost of assets on their balance sheet despite asset value changing over time.
Accruals accounting is a method where revenue and expenses are recorded at the point when a sale is made rather than when the cash is transferred. The matching principle is that related revenues and expenses should be recorded in the same period. This is to make clear links between the cost of an asset and its benefits.
The money measurement concept means that the only transactions to be recorded in financial statements are those that can be expressed in terms of money. Things that add value to the business such as staff talent and reputation cannot be recorded on financial statements despite having an impact on profit and loss.
The prudence concept encourages firms to be conservative in the recording of their assets and to estimate their liabilities reliably. This should lead to financial statements that provide a realistic picture of the firm's financial position.
