Did you ever force yourself to memorize your POA notes and exercises? Did you try to work out something while revising POA but cannot understand the reasons behind it? If yes, this could mean that you have a weak foundation in Principles of Accounts (POA).
Part of mastering the basics is to understand the basic accounting concepts and principles in POA. We aim to do so by explaining how each of these 13 accounting concepts and principles works.
Accounting Concept 1: Accounting Entity
Based on the Accounting Entity concept, the activities of a business are separate from the actions of the owners. Hence, the business and owner are treated as separate and different entities. All transactions are recorded from the point of view of the business. Therefore, only business-related transactions will be recorded in the books of accounts.
Accounting Concept 2: Going Concern
The Going Concern principle assumes that the business of the prepared accounts is in a healthy and stable condition. The business will then continue to be active in the “foreseeable future”. In other words, this concept states that a business will not be liquidated or be forced to discontinue operations due to any reason.
For business without Going Concern, the market value of its assets could be worth considerably lower to their value recorded in the accounts and financial statements. The business will thus have to make a statement in the accounts indicating the situation.
Accounting Concept 3: Accounting Period
An accounting period refers to a regular and fixed period of time covered by a set of financial statements. It defines the time range over which business transactions are recorded in the financial statements such as Income Statements (Statement of Financial Performance) and Balance Sheets (Statement of Financial Position). This time range can either be a month, a quarter, or a year. Stakeholders investing in businesses use this information to compare the business results over successive time periods.
Accounting Concept 4: Consistency
The consistency principle states that once a company adopts an accounting method or practice, it should not differ from period to period. That is, once an accounting policy is adopted the business should continue to follow it consistently in the future. This is to ensure a meaningful comparison between different accounting periods.
For example, once a business has decided to adopt the straight-line method as a depreciation policy for a non-current asset (such as machinery), the same method should be adopted throughout the economic useful life of the machinery.
However, if for any valid reasons the accounting policy is changed, a business must disclose the nature of change, the reasons for the change and its effects on the items of financial statements.
Accounting Concept 5: Monetary
According to the Monetary concept which is also known as the Money Measurement concept, a business only records transactions that can be expressed in terms of currency. Thus, items that cannot be expressed in terms of money such as an employee skill level, quality of customer support and product durability cannot be recorded in a financial statement.
Accounting Concept 6: Historical Cost
According to the Historical Cost concept, transactions are recorded at their original cost which is reflected in their source documents.
One advantage of the Historical Cost concept is that records are considered consistent, comparable, verifiable and reliable.
We can relate the historical cost to different aspects of the financial statement such as the balance sheet. For example, a property purchased by a company five years ago at $500,000 is to be recorded in their Balance Sheet (or Statement of Financial Position) at the same cost, despite the fluctuation in market value over the years.
Accounting Concept 7: Objectivity
According to the Objectivity principle, there must always be objectively verifiable evidence to support the occurrence of any business transaction. This is to ensure the financial statements will be free from opinions and biases.
For example, when a business purchases an equipment, it should receive a receipt as proof of payment. According to Objectivity principle, the business is to keep all bills and receipts as proof that a transaction has taken place.
Accounting Concept 8: Materiality
Generally, relevant information should be reported in the financial statements. Based on the Materiality Principle, an item on a financial statement can be considered material if omissions and errors of that item can influence decisions made by users of the financial statement.
Depending on the size of the business, if the amount involved is immaterial, it should be treated as an expense in the period of payment.
Accounting Concept 9: Accrual
According to the accrual basis of accounting, both incomes earned and expenses incurred are to be recorded in financial statements during the accounting period regardless of whether money has been received or paid.
By following this concept, it makes the information in the financial statement more accurate and reliable when looking at the financial situation of a business. For example, interest on loan expense incurred of $500 should be recorded in the Income Statement (Statement of Financial Performance) even though only $400 was paid up. Similarly, if the rent income earned was $2,000, then $2,000 should reflect in the Income Statement as income even though $2,500 was received. Adjustments at end of the year for the $100 outstanding interest on loan expense and $500 rent income received in advance need to be performed.
Accounting Concept 10: Matching
Income earned during an accounting period has to be matched with the expenses incurred in order to obtain a true and fair value of profit or loss for that accounting period. Income Statement (or Statement of Financial Performance) is the financial report to deliver the results of Matching principle.
Accounting Concept 11: Revenue Recognition
Revenue recognition is a generally accepted accounting principle (GAAP) that stipulates how and when revenue is to be recognized. Generally, revenue is earned when goods have been delivered or services have been provided.
For example, a sales transaction is deemed completed upon goods delivered and accepted by the customers, regardless of whether it was a cash or credit transaction. Similarly, a tuition service income is deemed earned upon lessons delivered, regardless of how much fees have been received.
Accounting Concept 12: Prudence
Prudence concept is also known as Conservatism concept. It states that profits and assets should not be overstated while losses and liabilities should not be understated. A business must report and adjust for probable losses immediately, even though the losses may not be confirmed yet. Profits, however, are only recorded when it is actually earned.
For example, any debt owed to the business by a debtor (trade receivable) who is insolvent, is deemed as a loss immediately, even if he has yet to be declared bankrupt.
Accounting Concept 13: Duality
Duality concept is the foundation of the universally applicable double-entry book-keeping system. It states that the twofold aspect of each transaction affects business in two different ways. That means every transaction has a double (or dual) effect on the position of a business as recorded in the accounts.
For example, when an owner invests cash into the business, there are two kinds of effect on the business. First, the cash assets of the business increase. Secondly, the Owner’s Equity section of the business increase. This particular effect serves to show an increase in the amount of investment made by the business owner.
How Does Understanding Basic Accounting Concepts Help in Real Life?
Understanding basic accounting concepts and principles does not just help you to pass your exams with flying colours. If you aspire to develop your career in the accounting profession in the future, you will be motivated to better understand why certain transactions have particular accounting treatments and the proper understanding and interpretation of the financial statements.
If you are thinking of starting your own business, with a proper understanding of these basic accounting concepts and principles, you will be equipped with relevant knowledge on interpreting financial information. This would greatly assist you in making relevant and sensible decisions in relation to your business. In short, you will benefit from these accounting concepts and principles.
We hope that this article has given a better understanding of the basic accounting principles in your POA syllabus.