Ten Basic Accounting Concepts

© Darden Graduate School of Business, 2005

1. The Entity. An accounting report communicates the activities of a specific entity,

and the reader of the report must understand the parameters of the reported-on
entity. Accounting reports directed to external readers usually include the
activities of the entire legal entity.

2. Accrual-versus Cash-Basis Accounting. There are two ways to measure and

report an entity's results -- a cash basis or an accrual basis. Using the cash basis,
an entity records an event in the period when the event has a cash effect, and
measures its financial status solely by the size of its bank account. Most entities
of any complexity use the accrual basis of accounting, which recognizes the
financial effect of an activity when the activity takes place, without regard to the
timing of its cash effects. Use of the accrual basis is required under generally
accepted accounting principles (GAAP) and leads to interesting allocation and
matching questions.

a. Allocation to Accounting Periods. Measuring financial success would be

simple if an entity had only to summarize and report its activities at the end
of its life. Cash results and accrual results would be exactly the same: we
would measure results by simply asking whether the entrepreneurs had more
cash at the end than they had at the start. Unfortunately, both management
and outsiders demand information about an entity's performance during
interim periods of its life. Accounting rules and conventions are designed to
allocate (or assign) the financial effect of an entity's activities to specific
periods of time.

b. Matching. Accounting standards and conventions are also designed to

comprehensively report all of a transaction's financial effects in the
applicable period. The objective of this matching principle is to report
revenues in the period in which they are earned and to report all expenses
related to those revenues in the same period.

3. Estimates and Judgment. Accounting reports are not as precise as they might
appear. In the process of allocating the financial effects of transactions over
different periods, estimates and judgments must be made.

4. Conservatism. In normal circumstances, the matching principle dictates the time

(the accounting period) when expenses will be recognized and charged against
revenue. However, if a current cost is to be matched against a future revenue,
and if there is a serious question about the certainty of that future revenue, the
expense will be recognized now, in the current period. This concept is known as
conservatism. The matching concept and the concept of conservatism are often
in conflict and balancing the two requires careful judgment.

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5. Transactions. Not all the activities of the business can be summarized in the
accounting reports, because some activities are not measurable and some
activities have not been completed. Accounting reports summarize completed
transactions, such as a sale of merchandise, the payment of an invoice, or the
purchase of equipment. Because accounting is numerical, accounting reports do
not deal with events that cannot be quantified, such as the invention of a new
product. Similarly, accounting reports usually do not include the effects of
transactions in process, although some uncompleted transactions may be
described verbally in accompanying footnotes.

6. Historical-Cost Accounting. For external accounting reports, transactions are

usually reported using the dollars involved at the time of transaction. So, for
example, when prior years' financial statements are re-published for comparative
purposes, they are not restated to recognize subsequent changes in the purchasing
power of the dollar.

In very specific and restricted situations, some assets may be adjusted up on a

balance sheet from its previously recorded historical cost (we will discuss those
situations later in the course). All assets may (in an application of the
conservatism concept) be written down, however, if their cash producing
potential drops below their historical cost. Where such a write-down is required,
it is referred to as a lower-of-cost-or-market adjustment.

7. Diversity and Consistency. For many transactions, there are a number of

alternative accounting methods available which temporarily produce different
accounting results. Where there are alternatives available, accounting standards
require that companies disclose, in a footnote to their reports, the alternative they
have selected, and that they use that alternative consistently from one reporting
period to another. Companies may change their accounting methods only with
good justification and with disclosure of the financial effects of the change.

8. Materiality. The ideal accounting report includes all information that might be
material to a reader, but leaves out irrelevant details. When making estimates
and judgments, managements logically focus their attention on items that have a
material effect on the accounting reports, and they tend to ignore immaterial
items. (“Material information” has been defined as information that has the
potential to effect economic decision making).

9. Relevance and Reliability. Accounting decisions frequently reflect a trade-off

between the relevance of the information provided and its reliability. For
example, information about an entity's cash and cash equivalents is surely
relevant to readers of the entity's accounting reports, and because the amount can
be measured reliably, accounting reports do reflect “cash and cash equivalents.”
However, even though the value associated with a patent or trademark would be
relevant to users, it is generally not reported due to concerns over the reliability

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 of the estimated dollar amount. Accounting reports for internal use typically
emphasize relevance even at the sacrifice of some reliability. Accounting reports
for external constituencies typically emphasize reliability at the expense of some
relevance.

10. Substance Over Form. Accounting reports are intended to measure the substance
of economic events, and accounting decisions are not necessarily driven by legal
determinations. Business transactions can be structured in many ways for legal
purposes, yet still have the same business substance. Therefore accounting is
concerned with the substance of activities and attempts to measure that reality.

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