Accounting Concepts

Basic Accounting ConceptsBasic Accounting Concepts

The basic accounting concepts are the ground rules The basic accounting concepts are the ground rules that govern how the accountants measure, process that govern how the accountants measure, process and communicate financial information. These and communicate financial information. These principles have been developed by the accounting principles have been developed by the accounting profession over the years to provide a consistent profession over the years to provide a consistent system of financial reporting in a constantly changing system of financial reporting in a constantly changing business environment ( Smith, Keith, et al, 1993).business environment ( Smith, Keith, et al, 1993).

Basic Accounting ConceptsBasic Accounting Concepts

These concepts assure users of the financial These concepts assure users of the financial statements that the reports are prepared in specific statements that the reports are prepared in specific ways so that they are reliable and comparable for the ways so that they are reliable and comparable for the usefulness of these reports rests on their reliability and usefulness of these reports rests on their reliability and comparability.comparability.

Purpose of Basic Accounting ConceptPurpose of Basic Accounting Concept

They help increase the confidence of financial statement users They help increase the confidence of financial statement users that the financial statements are presentationally faithful.that the financial statements are presentationally faithful.

They provide companies and accountants who prepare the They provide companies and accountants who prepare the financial statements with guidance on how to account for and financial statements with guidance on how to account for and report economic activities.report economic activities.

And they provide independent auditors of financial statements And they provide independent auditors of financial statements with basis for evaluating the fairness and completeness of those with basis for evaluating the fairness and completeness of those statements (Chasteen, Flaherty, O’Connor 1998)statements (Chasteen, Flaherty, O’Connor 1998)

Basic Accounting ConceptsBasic Accounting Concepts

(1)(1) ENTITY CONCEPTENTITY CONCEPT

-under the entity concept, the business is regarded as -under the entity concept, the business is regarded as having a separate and distinct personality from that having a separate and distinct personality from that of the owner’s– generating its own revenue, incurring of the owner’s– generating its own revenue, incurring its own expenses, owning its own assets, and owing its own expenses, owning its own assets, and owing its own liabilities (Smith, Keith 1993)its own liabilities (Smith, Keith 1993)

Basic Accounting ConceptsBasic Accounting Concepts

Business transaction – a business event that can be Business transaction – a business event that can be measured in terms of money that affect the enterprise. measured in terms of money that affect the enterprise. This would give rise to an exchange between the This would give rise to an exchange between the business and another party: value received and value business and another party: value received and value parted with.parted with.

Basic Accounting ConceptsBasic Accounting Concepts

(2) MONETARY UNIT CONCEPT(2) MONETARY UNIT CONCEPT

Money is used as a unit of measure in preparing the Money is used as a unit of measure in preparing the various financial reports of the company.various financial reports of the company.

The stable money concept assumes that, monetary The stable money concept assumes that, monetary unit of measure does not change value overtime, even unit of measure does not change value overtime, even if in fact it does. The assumption is made in order to if in fact it does. The assumption is made in order to ensure objectivity in reporting data on the financial ensure objectivity in reporting data on the financial statement.statement.

Basic Accounting ConceptsBasic Accounting Concepts

(3) TIME PERIOD CONCEPT(3) TIME PERIOD CONCEPT

Also known as Periodicity concept.Also known as Periodicity concept.

It divides the life of the business into regular intervals It divides the life of the business into regular intervals (usually one year) at the end of which financial (usually one year) at the end of which financial statements are prepared.statements are prepared.

This means that the economic activities undertaken This means that the economic activities undertaken during the life of an accounting entity are assumed to during the life of an accounting entity are assumed to be divisible into various artificial time periods for be divisible into various artificial time periods for financial reporting purposes.financial reporting purposes.

Basic Accounting ConceptsBasic Accounting Concepts

In choosing one year, the business has two options:In choosing one year, the business has two options:

(1) Calendar Year – a twelve month period beginning(1) Calendar Year – a twelve month period beginning January 1 and ending December 31January 1 and ending December 31

(2) Fiscal Year – The length of the fiscal period is (2) Fiscal Year – The length of the fiscal period is determined by the nature of the business and thedetermined by the nature of the business and the frequency of the need for data regarding financialfrequency of the need for data regarding financial condition and progress of the business. It does condition and progress of the business. It does not start Jan 1 and end Dec 31. not start Jan 1 and end Dec 31.

Basic Accounting ConceptsBasic Accounting Concepts

(4) REVENUE REALIZATION CONCEPT(4) REVENUE REALIZATION CONCEPT

RevenueRevenue is the inflow of assets that results from is the inflow of assets that results from producing goods or rendering services.producing goods or rendering services.

Revenue RealizationRevenue Realization concept provides that income is concept provides that income is recognized when earned regardless whether cash is recognized when earned regardless whether cash is received. This means that both of the following received. This means that both of the following conditions are met:conditions are met:

(1) The earning process is complete(1) The earning process is complete (2) An exchange has taken place ( Smith, Keith 1993)(2) An exchange has taken place ( Smith, Keith 1993)

Basic Accounting ConceptsBasic Accounting Concepts

Two points of income recognitionTwo points of income recognition

(1) Income is considered earned when services are (1) Income is considered earned when services are

fully rendered.fully rendered.

(2) Income is considered earned when goods or(2) Income is considered earned when goods or

merchandise are fully delivered.merchandise are fully delivered.

Basic Accounting ConceptsBasic Accounting Concepts

(5) ACCRUAL CONCEPT(5) ACCRUAL CONCEPT

This concept requires that income be recorded when This concept requires that income be recorded when earned regardless whether cash is received. And an earned regardless whether cash is received. And an expense be recognized when incurred (e.g., when expense be recognized when incurred (e.g., when services or benefits have already been received) services or benefits have already been received) regardless whether payment is made.regardless whether payment is made.

To apply the accrual concept, accountants have To apply the accrual concept, accountants have developed the developed the accrual accountingaccrual accounting..

Basic Accounting ConceptsBasic Accounting Concepts

The accrual method of accounting attempts to record The accrual method of accounting attempts to record the financial effects on a company of transactions and the financial effects on a company of transactions and other events and circumstances in the periods in which other events and circumstances in the periods in which those transactions, events and circumstances occur those transactions, events and circumstances occur rather than only the periods in which cash is received rather than only the periods in which cash is received or paid by the firm.or paid by the firm.

This means that the accrual accounting consist of all This means that the accrual accounting consist of all techniques developed by accountants to apply both techniques developed by accountants to apply both accrual and matching concepts. (Needles, accrual and matching concepts. (Needles, Powers..1999)Powers..1999)

Basic Accounting ConceptsBasic Accounting Concepts

(6) MATCHING CONCEPT(6) MATCHING CONCEPT

This concepts states that all expenses incurred to This concepts states that all expenses incurred to generate revenues must be recorded in the same generate revenues must be recorded in the same period that the income are recorded to properly period that the income are recorded to properly determine net income or net loss of the period.determine net income or net loss of the period.

There is a cause and effect recognition implicit in this There is a cause and effect recognition implicit in this definition.definition.

Basic Accounting ConceptsBasic Accounting Concepts

Example:Example: Revenues earned in June and collected in June P 30,000Revenues earned in June and collected in June P 30,000 Revenues earned in June but collected in July 20,000Revenues earned in June but collected in July 20,000 Revenues earned in May but collected only in June 10,000Revenues earned in May but collected only in June 10,000 Expenses incurred in June and paid in June 10,000Expenses incurred in June and paid in June 10,000 Expenses incurred in June but payable in July 15,000Expenses incurred in June but payable in July 15,000 Expenses incurred in May but paid in June 7,000Expenses incurred in May but paid in June 7,000

Basic Accounting ConceptsBasic Accounting Concepts

(7) OBJECTIVITY OR RELIABILITY CONCEPT(7) OBJECTIVITY OR RELIABILITY CONCEPT

This concept requires that all transactions must be This concept requires that all transactions must be evidences by business documents free from personal evidences by business documents free from personal biases and independent experts (e.g. CPA) can verifybiases and independent experts (e.g. CPA) can verify

((8) COST CONCEPT8) COST CONCEPT

Assets, i.e., resources acquired by the business, must Assets, i.e., resources acquired by the business, must be recorded at be recorded at acquisition priceacquisition price (i.e. what you have (i.e. what you have given up in exchange for an ownership of an asset) given up in exchange for an ownership of an asset) and no adjustments are made on this valuation in later and no adjustments are made on this valuation in later periods.periods.

Basic Accounting ConceptsBasic Accounting Concepts

The cost principle assumes that assets are required in The cost principle assumes that assets are required in business transactions conduCted at arm’s length business transactions conduCted at arm’s length transactions, i.e. transaction between a buyer and a transactions, i.e. transaction between a buyer and a seller at the fair value prevailing at the time of seller at the fair value prevailing at the time of transaction.transaction.

For non cash transaction conducted at arm’s length, For non cash transaction conducted at arm’s length, the cost principle assumes that the market value of the the cost principle assumes that the market value of the resources given up in the transaction provides reliable resources given up in the transaction provides reliable evidence for the valuation of the of the item acquired evidence for the valuation of the of the item acquired ( Dyckman, T Dukes, Davis C. 1998)( Dyckman, T Dukes, Davis C. 1998)

Basic Accounting ConceptsBasic Accounting Concepts

The cost principle provides guidance primarily at the The cost principle provides guidance primarily at the initial acquisition date. Once acquired, the original cost initial acquisition date. Once acquired, the original cost basis of some assets in then subjected to depreciation. basis of some assets in then subjected to depreciation. Depletion, amortization, etc, overtime to reflect the said Depletion, amortization, etc, overtime to reflect the said assets in the Statement of Financial Position in a more assets in the Statement of Financial Position in a more realistic valuation.realistic valuation.

Basic Accounting ConceptsBasic Accounting Concepts

(9) GOING CONCERN CONCEPT(9) GOING CONCERN CONCEPT

In the absence of information to the contrary, this In the absence of information to the contrary, this concept assumes that the business is to continue its concept assumes that the business is to continue its operation indefinitely.operation indefinitely.

This means that the business will stay in operation for This means that the business will stay in operation for a period of time sufficient to carry out contemplated a period of time sufficient to carry out contemplated operations, contracts and commitments.operations, contracts and commitments.

Basic Accounting ConceptsBasic Accounting Concepts

(10) CONSERVATISM CONCEPT(10) CONSERVATISM CONCEPT

This concept has a powerful influence in valuing assets This concept has a powerful influence in valuing assets and measuring net income. When faced with uncertainties, and measuring net income. When faced with uncertainties, the accountant traditionally leans towards the direction of the accountant traditionally leans towards the direction of caution, choosing the method that would give the business caution, choosing the method that would give the business a less favorable condition and lower net income.a less favorable condition and lower net income.

The reason behind this assumption is that investors prefer The reason behind this assumption is that investors prefer information that does not unnecessary raise expectations.information that does not unnecessary raise expectations.

Basic Accounting ConceptsBasic Accounting Concepts

(11) CONSISTENCY CONCEPT(11) CONSISTENCY CONCEPT

This concept states that once a method is adopted, it This concept states that once a method is adopted, it must not be changed from year to year to allow must not be changed from year to year to allow comparability of financial statements between years comparability of financial statements between years and between businesses.and between businesses.

Basic Accounting ConceptsBasic Accounting Concepts

(12)(12) MATERIALITY CONCEPTMATERIALITY CONCEPT

This concept refers to relative importance of an item This concept refers to relative importance of an item or event. An item/event is considered material if or event. An item/event is considered material if knowledge of it would influence the decision of knowledge of it would influence the decision of prudent users of financial statementsprudent users of financial statements

Basic Accounting ConceptsBasic Accounting Concepts

(13)(13) DISCLOSURE CONCEPTDISCLOSURE CONCEPT

All relevant and material events affecting All relevant and material events affecting conditions/position of a business and the results of its conditions/position of a business and the results of its operations must be communicated to users of operations must be communicated to users of financial statements.financial statements.

Basic Accounting ConceptsBasic Accounting Concepts

Supplemental information is disclosed in a variety of Supplemental information is disclosed in a variety of ways includingways including

(1) Parenthetical comments or modifying comments (1) Parenthetical comments or modifying comments placed on the face of the financial statementplaced on the face of the financial statement

(2) Disclosure notes conveying additional insights about (2) Disclosure notes conveying additional insights about the company operations, accounting principles, the company operations, accounting principles, contractual agreements, and pending litigation.contractual agreements, and pending litigation.