Accounting concepts and principles

Last time

Before we start: last time, in Accounting ratios, inter-firm comparison and interested parties, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

The rules behind the rules

Why is inventory valued at the lower of cost and net realisable value? Why do we charge depreciation? Why are the owner's drawings kept separate? Each answer is an accounting concept. This lesson covers the concepts, and how to apply each to a question.

Business entity and duality

Business entity: the business is treated as separate from its owner. Only business transactions are recorded; the owner's private spending is drawings. Duality: every transaction has two aspects, a debit and a credit. This is the basis of double entry. These two concepts underlie everything else.

Money measurement and historic cost

Money measurement: only items that can be measured in money are recorded. Staff skill and customer loyalty are not. Historic cost: assets are recorded at what they cost, not what they might be worth today. Both are reasons why the accounts do not show everything about a business.

Going concern

Going concern: the business is assumed to continue trading for the foreseeable future. So assets are shown at cost less depreciation, not at what they would fetch in a forced sale. If the business is closing, assets would be valued at what they could be sold for.

Matching, or accruals

Matching: income and expenses are recorded in the period they relate to, not when cash is paid or received. It explains accruals, prepayments and depreciation. It gives a true profit for each year.

Prudence

Prudence: profits and assets should not be overstated, and losses should be provided for as soon as they are likely. It explains the allowance for irrecoverable debts and valuing inventory at the lower of cost and net realisable value. But it does not mean deliberately understating profit.

Realisation, consistency and materiality

Realisation: revenue is recognised when goods or services pass to the customer, not when the order is placed or the cash arrives. Consistency: the same methods are used each year, so results can be compared. Materiality: small items, such as a stapler, can be treated simply as an expense, because they do not affect the picture.

Concepts in action

Questions often describe a practice and ask which concept it applies. Here are the common ones.

Applying a concept

Name the concept, explain what it means, and then link it to the situation in the question. For example: a provision for doubtful debts applies prudence, because likely losses are provided for now, so profit is not overstated. If asked for a reason other than following principles, give a practical one, such as better cash planning.

Why concepts matter

They make accounts reliable, so users can trust them. They make accounts comparable between years and between businesses. And they guide accountants when a situation is not covered by a specific rule.

Mistakes that lose marks

Mistake one: naming a concept without explaining it. Mistake two: confusing prudence with matching. Mistake three: an explanation that does not link to the question's situation. The fix: name, explain, apply.

The full-marks tip

The full-marks tip: name the concept, explain it in one sentence, then apply it to the case. Prudence is about not overstating; matching is about the right period.

On one card

So, on one card: accounting concepts. Keep it for revision.