FUNDAMENTAL CONCEPTS

OF ACCOUNTING

Accounting is the language of business and it is used to communicate financial

information. In order for that information to make sense, accounting is based on
12 fundamental concepts. These fundamental concepts then form the basis for
all of the Generally Accepted Accounting Principles (GAAP). By using these
concepts as the foundation, readers of financial statements and other accounting
information do not need to make assumptions about what the numbers mean.

For instance, the difference between reading that a truck has a value of $9000
on the balance sheet and understanding what that $9000 represents is huge.
Can you turn around and sell the truck for $9000? If you had to buy the truck
today, would you pay $9000? Or, perhaps the original purchase price of the truck
was $9000. All of these assumptions lead to very different evaluations of the
worth of that asset and how it contributes to the company’s financial situation.

For this reason it is imperative to know and understand the eleven key concepts.

Users of financial statements

• 1. Credit and equity investors – focus of this course.

• 2. Government – regulatory bodies (public utility commissions, tax authorities (IRS and others.
• 3. General public, special interest groups and others. See shareholder proposals.

International Accounting Standards

1. Principal Financial Statements

• Balance Sheet – provides a snapshot of a corporation’s assets, liabilities and stockholders’ equity at a
given point in time. In the US, this is usually done quarterly and annually.
• Assets and liabilities are listed in descending order of liquidity, frequently with subtotals such as
current assets and current liabilities.
• Primarily prepared based on historical cost, but there are exceptions. Think conservative.
Marketable securities available for sale are carried at market value. Long-term assets may become
impaired and written down, oil reserves may be written down. Recoveries aren’t written up.
• Income statement – presentation of revenues and expenses over some time period – usually quarterly
or annually.
• The opportunity exists for game playing with the classification of items as
• Operating versus non-operating
• Recurring or nonrecurring
• Extraordinary –unusual and infrequent
• Revenue recognition

ELEVEN KEY ACCOUNTING CONCEPTS OR Conventions

Entity
Accounts are kept for entities and not the people who own or run the company. Even in proprietorships and
partnerships, the accounts for the business must be kept separate from those of the owner(s).

Money-Measurement
For an accounting record to be made it must be able to be expressed in monetary terms. For this reason,
financial statements show only a limited picture of the business. Consider a situation where there is a labor
strike pending or the business owner’s health is failing; these situations have a huge impact on the
operations and financial security of the company but this information is not reflected in the financial
statements.
Going Concern
Accounting assumes that an entity will continue to operate indefinitely. This concept implies that financial
statements do not represent a company’s worth if its assets were to be liquidated, but rather that the assets
will be used in future operations. This concept also allows businesses to spread (amortize) the cost of an
asset over its expected useful life.
Cost
An asset (something that is owned by the company) is entered into the accounting records at the price paid
to acquire it. Because the “worth” of an asset changes over time it would be impossible to accurately record
the market value for the assets of a company. The cost concept does recognize that assets generally
depreciate in value and so accounting practice removes the depreciation amount from the original cost,
shows the value as a net amount, and records the difference as a cost of operations (depreciation expense.)
Look at the following example:
Truck $10,000 purchase price of the truck
Less depreciation $ 1,000 amount deducted as a depreciation expense
Net Truck: $ 9,000 net book-value of the truck
The $9000 simply represents the book value of the truck after depreciation has been accounted for. This
figure says nothing about other aspects that affect the value of an item and is not considered a market price.
Dual Aspect
This concept is the basis of the fundamental accounting equation:

Assets = Liabilities + Equity

1. Assets are what the company owns.

2. Liabilities are what the company owes to creditors against those assets
3. Equity is the difference between the two and represents what the company owes to its
investors/owners.

All accounting transactions must keep this equation balanced so when there is an increase on one side there
must be an equal increase on the other side or an equal decrease on the same side.
Objectivity
The objectivity concept states that accounting will be recorded on the basis of objective evidence (invoices,
receipts, bank statement, etc…). This means that accounting records will initiate from a source document
and that the information recorded is based on fact and not personal opinion.
Time Period
This concept defines a specific interval of time for which an entity’s reports are prepared. This can be a
fiscal year (Mar 1 – Feb 28), natural year (Jan 1 – Dec 31), or any other meaningful period such as a quarter
or a month.
Conservatism
This requires understating rather than overstating revenue (income) and expense amounts that have a degree
of uncertainty. The rule is to recognize revenue when it is reasonably certain and recognize expenses as
soon as they are reasonably possible. The reasons for accounting in this manner are so that financial
statements do not overstate the company’s financial position. Accounting chooses to err on the side of
caution and protect investors from inflated or overly positive results.
Realization
Revenues are recognized when they are earned or realized. Realization is assumed to occur when the seller
receives cash or a claim to cash (receivable) in exchange for goods or services. This concept is related to
conservatism in that revenue (income) is only recorded when it actually occurs and not at the point in time
when a contract is awarded. For instance, if a company is awarded a contract to build an office building the
revenue from that project would not be recorded in one lump sum but rather it would be divided over time
according to the work that is actually being done.
Matching
To avoid overstatement of income in any one period, the matching principle requires that revenues and
related expenses be recorded in the same accounting period. If you bill $20,000 of services in a month, in
order to accurately represent the income for the month you must report the expenses you incurred while
generating that income in the same month.
Consistency
once an entity decides on one method of reporting (i.e. method of accounting for inventory) it must use that
same method for all subsequent events. This ensures that differences in financial position between reporting
periods are a result of changed in the operations and not to changes in the way items are accounted for.
Materiality
Accounting practice only records events that are significant enough to justify the usefulness of the
information. Technically, each time a sheet of paper is used, the asset “Office supplies” is decreased by an
infinitesimal amount but that transaction is not worth accounting for.
By understanding and applying these principles you will be able to read, prepare, and compare financial
statements with clarity and accuracy. The bottom-line is that the ethical practice of accounting mandates
reporting income as accurately as possible and when there is uncertainty, choosing to err on the side of
caution.

Accounting Concepts and Conventions

Introduction
Accounting concepts and conventions as used in accountancy are the rules and guidelines by that the
accountant lives. All formal accounting statements should be created, preserved and presented
according to the concepts and conventions that follow.
In the United Kingdom, four of the following accounting concepts are laid down in Statement of
Standard Accounting Practice number 2 (SSAP 2: Disclosure of Accounting Policies), they are the

• Going concern concept

• Accruals or matching concept
• Consistency concept
• Prudence concept
Going concern
This concept is the underlying assumption that any accountant makes when he prepares a set of
accounts. That the business under consideration will remain in existence for the foreseeable future. In
addition to being an old concept of accounting, it is now, for example, part of UK statute law: reference
to it can be found in the Companies Act 1985. Without this concept, accounts would have to be drawn
up on the 'winding up' basis. That is, on what the business is likely to be worth if it is sold piecemeal at
the date of the accounts. The winding up value would almost certainly be different from the going
concern value shown. Such circumstances as the state of the market and the availability of finance are
important considerations here.

Accruals
Otherwise known as the matching principle. The purpose of this concept is to make sure that all
revenues and costs are recorded in the appropriate statement at the appropriate time. Thus, when a
profit statement is compiled, the cost of goods sold relevant to those sales should be recorded
accurately and in full in that statement. Costs concerning a future period must be carried forward as a
prepayment for that period and not charged in the current profit statement. For example, payments
made in advance such as the prepayment of rent would be treated in this way. Similarly, expenses paid
in arrears must, although paid after the period to that they relate, also be shown in the current
period's profit statement: by means of an accruals adjustment.

CoNsi$tency
Because the methods employed in treating certain items within the accounting records may be varied
from time to time, the concept of consistency has come to be applied more and more rigidly. For
example, because there can be no single rate of depreciation chargeable on all fixed assets, every
business has potentially a lot of discretion over the precise rate it chooses to use. However, if it wishes,
a business may vary the rates at which it charges depreciation and alter the profits it reports at the
same time. Consider the effects on profit of charging depreciation at 15% this year on £10,000 worth
of fixed assets and then charging depreciation at 10% next year on the same £10,000 worth of fixed
assets. This year you would charge £1,500 against profits and next year it would be only £1,000, using
the straight line method of providing for depreciation.
Because of these sorts of effects, it is now accepted practice that when a company chooses to treat
items such as depreciation in a particular way in the accounts it should go on using that method year
after year. If it is NECESSARY to change the method being employed or the rates being charged then
an explanation of the change and the effects it is having on the results must be shown as a note to the
accounts being presented.
Prudence
Otherwise known as conservatism. It is this concept more than any other that has given rise to the
idea that accountants are pessimistic boring people!! Basically the concept says that whenever there
are alternative procedures or values, the accountant will choose the one that results in a lower profit, a
lower asset value and a higher liability value. The concept is summarised by the well known phrase
'anticipate no profit and provide for all possible losses'. Thus, undue optimism can never be part of the
make up of an accountant! The danger is that if an optimistic view of profits is given then dividends
may be paid out of profits that have not been earned.
Objectivity
The objectivity concept requires an accountant to draw up any accounts, and further analysis, only on
the basis of objective and factual information. Thus, this concept attempts to ensure that if, for
example, 100 accountants were to draw up a set of accounts for one business, there would be 100
identical accounting statements prepared. Everyone would be obtaining and using only facts. The
problem here is that there are many aspects of accounting ensuring that objectivity cannot be
universally applicable in the preparation of accounts. For example, with fixed assets: the cost of a van
must be known at its purchase: say £30,000. However, how long will this van be in service? I say five
years, my colleague could say 10 years. If I prepare the accounts using the straight line method of
depreciation calculation, I would provide £30,000 ÷ 5 = £6,000 each year for depreciation;
my colleague would charge £30,000 ÷ 10 = £3,000 each year for depreciation; and both of us could
be corrected! The problem is that with an issue such as depreciation we are not always able to be
objective.
Duality Duality
This is the very foundation of the universally applicable double entry book keeping system and it stems
from the fact that every transaction has a double (or dual) effect on the position of a business as
recorded in the accounts. For example, when an asset is bought, another asset cash (or bank) is also
and simultaneously decreased OR a liability such as creditors is also and simultaneously increased.
Similarly, when a sale is made the asset of stock is reduced as goods leave the business and the asset
of cash is increased (or the asset of debtors is increased) as cash comes into the business (or a
promise to pay is made and accepted). Every financial transaction behaves in this dual way.
Entity
Otherwise known as the 'accounting entity' concept. The idea here is that the financial transactions of
one individual or a group of individuals must be kept separate from any unrelated financial
transactions of those same individuals or group. The best example here concerns that of the sole
trader or one man business: in this situation you may have the sole trader taking money by way of
'drawings': money for his own personal use. Despite it being his business and apparently his money,
there are still two aspects to the transaction: the business is 'giving' money and the individual is
'receiving' money. So, the affairs of the individuals behind a business must be kept separate from the
affairs of the business itself.
Co$t
This concept is based on the notion that only the costs paid to acquire an asset are relevant and thus
should be the only costs to be shown in the accounts. For example, fixed assets are shown on the
balance sheet at the price paid to acquire them; that is, their historic cost less depreciation written off
to date.
There is a problem in this area. That is the one of value. The accountant will rarely talk of value in this
context since the use of such a term implies personal bias. After all, the value of an asset as far as I
am concerned may be different to the value of the same asset as far as you may be concerned. The
application of the cost concept ensures that subjective judgements play no part in the drawing up of
accounting statements.
Monetary Measurement … £££
The money measurement concept is one of the simpler concepts. It simply and clearly states that only
those transactions that are true financial transactions may be accounted for. That is, only those
transactions that may be expressed in money values (whatever the currency) are of interest to the
accountant.
Materiality
We are concerned here with the idea that accountants should concern themselves only with matters
that are significant because of their size and should not consider trivial matters. The problem, of
course, is in deciding what is and what is not material: we are concerned here with RELATIVE
IMPORTANCE. As far as an individual is concerned, the loss of a £10 would be important and
MATERIAL. As far as Chevron or Barclays Bank are concerned, the loss of £10 could be considered
unimportant in many circumstances and therefore immaterial: please note I am not suggesting that
fraud or carelessness in the handling of money is acceptable!!
Realisation
The realisation concept helps the accountant to determine the point at that he feels that a transaction
is certain enough for the profit to be made on it to be calculated and taken to the profit and loss
account. Realisation occurs when a sale is made to a customer. The basic rule is that revenue is
created at the moment a sale is made, and not when the account is later settled by cheque or by cash.
Thus, profit can be taken to the profit and loss account on sales made, even though the money has not
been collected. The sale is deemed to be made when the goods are delivered, and thus profit cannot
be taken to the profit and loss account on orders received and not yet filled. An exception to this rule
would be a long term contract that involve payments on account before completion of the work.
Stable money
Normal or historic cost accounting assumes that transactions occurring over a period of time can be
measured in terms of a single, stable measuring unit eg Pounds, Dollars ... This means that, in the UK,
all accounts are drawn up in Pounds; and this year's balance sheet can be compared with last year's
balance sheet. Consequently,
if fixed assets brought down from last year were £1,000 and a further £500 of fixed assets were
bought during this year, we would say fixed assets carried down from this year were worth £1,000 +
500 = £1,500. All of this gives rise to consistency but there is a problem with reality inflation means
that very few currencies are truly stable.
Many attempts have been made at solving this problem, incidentally, but, in the UK, for example, all
efforts have proven useless. The only really meaningful accounting directive ever enacted on this
subject was withdrawn by the accounting bodies in the UK several years ago.

Conclusions
These, then, are the basic concepts and conventions on which the accountant bases all of his
accounting work. We can see evidence of such work in the published annual reports and accounts that
all publicly quoted companies are required to prepare and publish. The concepts and conventions also
apply to the millions of businesses world wide that do not publish their accounts.
When we look at the work of an accountant we can see evidence that he has followed these concepts
and conventions: we will see accrued expenses, we will see that there is a statement to the effect that
the accounts have been drawn up on the basis of the going concern concept … and so on.
There are problems with these concepts and conventions, however, in that some of them conflict with
each other. For example, money measurement and materiality can conflict, consistency and materiality
can conflict. Have a look at the next page Conflicts in accounting concepts to explore some of these
issues in more detail.