CONCEPTS OF ACCOUNTING WITH EXAMPLES

These are the basic ideas or assumptions under the theory base of accounting that provide certain
working rules for the accounting activities of an organization. There are 13 important basic
accounting concepts that are to be followed by companies to prepare true and fair financial
statements.

Business entity concept: This concept states that a business is a separate entity from its owners. This
means that the business's financial transactions are recorded separately from the owner's personal
financial transactions.

Example:

A sole proprietorship is a business owned by one person. However, for accounting purposes, the sole
proprietorship is treated as a separate entity from the owner. This means that the business's income
and expenses are recorded separately from the owner's personal income and expenses.

Money measurement concept: This concept states that only financial transactions that can be
measured in monetary terms can be recorded in the accounting records.

Example:

A company may have a valuable brand name, but it cannot be recorded in the accounting records
because it cannot be measured in monetary terms. However, the company could record the costs
associated with developing and maintaining the brand name, such as advertising and marketing costs.

Going concern concept: This concept assumes that the business will continue to operate in the
foreseeable future. This assumption is necessary for preparing financial statements that are relevant and
useful to decision-makers.

Example:

A company's financial statements are prepared on the assumption that the company will continue to
operate in the foreseeable future. This means that the company's assets and liabilities are valued at
their expected future value, rather than their current market value.

Accounting period concept: This concept states that the financial performance of a business should be
reported over regular intervals of time, such as a month, quarter, or year. This allows users of financial
statements to track the business's progress over time and compare its performance to other businesses.

Example:

A company's fiscal year typically starts on January 1 and ends on December 31. However, a company can
choose a different fiscal year if it makes more business sense. For example, a retail company may choose
to have a fiscal year that ends on January 31, so that it can include the holiday season in its financial
statements.

Cost concept: This concept states that assets should be recorded at their historical cost, which is the
amount that was paid to acquire them.
Example:

A company purchases a new machine for $10,000. The machine is recorded in the accounting records at
a cost of $10,000, regardless of its current market value.

The dual aspect concept: or duality principle, is a fundamental accounting concept that states that every
business transaction has two equal and opposite effects on the accounting equation. The accounting
equation is a formula that shows the relationship between a business's assets, liabilities, and equity.

Assets = Liabilities + Equity

The dual aspect concept is the basis for double-entry accounting, which is the accounting system used
by most businesses. In double-entry accounting, every transaction is recorded in two separate accounts,
one account for the debit and one account for the credit.

Debit = Credit

When a transaction increases an asset or decreases a liability or equity account, it is recorded as a debit.
When a transaction decreases an asset or increases a liability or equity account, it is recorded as a
credit.

Here is an example of the dual aspect concept in action:

A company purchases inventory on credit for $10,000. This transaction has two equal and opposite
effects on the accounting equation:

Debit: Inventory (asset) increases by $10,000.

Credit: Accounts payable (liability) increases by $10,000.

The total assets of the company increase by $10,000, and the total liabilities of the company also
increase by $10,000. The accounting equation is still in balance, and the dual aspect concept has been
satisfied.

The revenue recognition concept: is a fundamental accounting principle that states that revenue should
be recognized in the period in which it is earned, not necessarily when cash is received. This concept is
important because it allows businesses to provide a more accurate picture of their financial
performance to investors and other stakeholders.

To determine when revenue is earned, accountants consider the following factors:

The goods or services have been delivered to the customer.

The customer has a legal obligation to pay for the goods or services.

The amount of revenue can be reasonably estimated.

The collection of the revenue is reasonably assured.

Once these criteria have been met, the revenue can be recognized.

Here is an example of the revenue recognition concept in action:

A company sells a product to a customer on credit. The customer takes possession of the product on
January 1, but does not pay for it until February 1. The company can recognize the revenue from the
sale on January 1, because all of the criteria for revenue recognition have been met:

The goods have been delivered to the customer.

The customer has a legal obligation to pay for the goods.

The amount of revenue can be reasonably estimated.

The collection of the revenue is reasonably assured.

Matching concept: This concept states that expenses should be matched with the revenue that they
generate. This allows users of financial statements to see the true cost of generating revenue and to
make informed decisions about the business.

Example:

A company sells a product for $100. The company incurs $50 in costs to produce the product. The
matching concept requires that the company record $50 in expense in the same accounting period in
which it records $100 in revenue.

The full disclosure concept: is an accounting principle that requires businesses to disclose all material
information about their financial position and performance in their financial statements. This
information includes both positive and negative information, and it should be presented in a way that is
clear, concise, and understandable to users of the financial statements.

The full disclosure concept is important because it helps to ensure that investors and other stakeholders
have the information they need to make informed decisions about the business. This information can be
used to assess the business's risk and return profile, and to make decisions about whether to invest in
the business or lend it money.

Here are some examples of information that should be disclosed under the full disclosure concept:

Accounting policies: Businesses should disclose their accounting policies so that users of the financial
statements can understand how the financial statements were prepared.

Significant accounting estimates: Businesses should disclose any significant accounting estimates that
were made in the preparation of the financial statements.

Contingent liabilities: Businesses should disclose any contingent liabilities that they have. Contingent
liabilities are potential liabilities that may or may not become actual liabilities in the future.

Segment information: Businesses should disclose information about their different segments, such as
their products, services, and geographic locations. This information can help users of the financial
statements to understand the different sources of the business's revenue and expenses.
Related-party transactions: Businesses should disclose all significant related-party transactions. Related-
party transactions are transactions between the business and its related parties, such as its officers,
directors, and major shareholders.

The full disclosure concept is a fundamental accounting principle that helps to ensure that financial
statements are accurate, reliable, and transparent.

Here is an example of the full disclosure concept in action:

A company has a significant contingent liability related to a lawsuit that has been filed against it. The
company discloses this information in its financial statements, along with an estimate of the potential
financial impact of the lawsuit. This information allows users of the financial statements to assess the
company's risk profile and to make informed decisions about whether to invest in the company or lend
it money.

The full disclosure concept is an important part of ensuring that financial markets are fair and efficient.
By requiring businesses to disclose all material information about their financial position and
performance, the full disclosure concept helps to ensure that investors and other stakeholders have the
information they need to make informed decisions.

The consistency concept: is an accounting principle that requires businesses to use the same accounting
methods and principles from one period to the next. This concept is important because it allows users of
financial statements to make meaningful comparisons between periods.

There are a few exceptions to the consistency concept. For example, businesses are allowed to change
accounting methods if the new method is required by law or if it provides a more accurate presentation
of the business's financial position and performance. However, businesses must disclose any changes to
their accounting methods and the financial impact of those changes.

Here is an example of the consistency concept in action:

A company uses the straight-line method to depreciate its assets. The company must continue to use
the straight-line method to depreciate its assets in future periods, unless there is a valid reason to
change methods. If the company does decide to change to a different depreciation method, such as the
accelerated depreciation method, it must disclose the change and the financial impact of the change in
its financial statements.

The consistency concept is an important accounting principle because it helps to ensure that financial
statements are accurate, reliable, and comparable. This information can be used by investors and other
stakeholders to make informed decisions about the business.

The conservatism concept: is an accounting principle that requires businesses to err on the side of
caution when making accounting judgments. This means that businesses should recognize expenses and
liabilities as soon as possible, but only recognize revenues and assets when they are reasonably assured.

The conservatism concept is based on the idea that it is better to underestimate profits than to
overestimate them. This is because overestimating profits can lead investors and other stakeholders to
make poor decisions about the business.
Here is an example of the conservatism concept in action:

A company has a significant inventory of obsolete products. The company should record a loss for the
obsolete inventory, even if the products have not yet been sold. This is because the company is unlikely
to be able to sell the products for their full value.

The materiality concept: is an accounting principle that states that only items that are likely to influence
the decisions of users of financial statements should be recorded or reported in detail. This means that
small or insignificant items can be omitted or aggregated with other items.

The materiality concept is important because it allows accountants to focus on the most important
information and to avoid cluttering the financial statements with unnecessary details. This makes the
financial statements easier to read and understand for users.

To determine whether an item is material, accountants consider the following factors:

The size of the item in relation to the company's overall financial position and performance.

The nature of the item. Some items, such as fraud or errors, are always material, regardless of their size.

The cumulative effect of similar items. A number of small items may be material together, even if they
are not material individually.

Here is an example of the materiality concept in action:

A company has a $100 million revenue and a $10 million net income. The company also has a $10,000
loss from a theft of inventory. The loss from the theft is immaterial because it is small in relation to the
company's overall financial position and performance.

The objectivity concept: is an accounting principle that requires accountants to record and report
financial information in an unbiased and fair manner. This means that accountants should not allow
their personal opinions or biases to influence their accounting decisions.

The objectivity concept is important because it helps to ensure that financial statements are accurate
and reliable. This information can be used by investors and other stakeholders to make informed
decisions about the business.

To ensure objectivity, accountants should:

Use verifiable documentation to support all accounting entries.

Consult with other accountants and auditors to get feedback on their accounting decisions.

Be aware of their own biases and take steps to mitigate them.

Here is an example of the objectivity concept in action:

A company has a large inventory of products that are no longer in demand. The company's management
team wants to record the inventory at its full value, even though it is unlikely to be sold for that price.
The accountant should not allow the management team's opinion to influence their accounting decision.
Instead, the accountant should record the inventory at its net realizable value, which is the amount that
the company expects to receive from selling the inventory.
The objectivity concept is a fundamental accounting principle that helps to ensure that financial
statements are accurate, reliable, and useful to decision-makers.

TYPES OF BUSINESS
Sole proprietorship: A sole proprietorship is a business owned and operated by one person. Sole
proprietorships are the simplest type of business structure to set up and maintain, but they also offer
the least amount of liability protection.

Partnership: A partnership is a business owned and operated by two or more people. Partnerships offer
more liability protection than sole proprietorships, but they can also be more complex to manage.

Limited liability company (LLC): An LLC is a business structure that offers limited liability protection to its
owners. LLCs are popular with small businesses because they offer the flexibility of a partnership with
the liability protection of a corporation.

Corporation: A corporation is a legal entity that is separate from its owners. Corporations offer the
strongest liability protection to their owners, but they can also be the most complex type of business
structure to set up and maintain.

C-Corporation: A C-corporation, also known as a C corp, is a type of corporation that is taxed separately
from its owners. This means that the corporation pays taxes on its profits, and the owners pay taxes on
their share of the profits when they are distributed as dividends.

S-Corporation: An S-corporation, also known as an S corp, is a type of corporation that elects to pass
corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes.
This means that the S-corporation itself does not pay taxes on its income; instead, the shareholders
report the income and losses on their personal tax returns.

Nonprofit Organization: A nonprofit organization, also known as a not-for-profit organization, is a legal

entity that is exempt from paying federal income taxes under Section 501(c) of the Internal Revenue
Code. Nonprofit organizations are formed to pursue a charitable, religious, educational, or other social
purpose, and their profits are reinvested in the organization to further its mission.

Cooperative: A cooperative, also known as a co-op, is a business or organization owned and operated by
its members for their mutual benefit. Cooperatives are based on the principles of self-help, self-
responsibility, democracy, equality, equity, and solidarity .Cooperatives are found in all sectors of the
economy, including agriculture, consumer goods, housing, finance, and healthcare.

Franchise: A franchise is a business arrangement in which one party (the franchisor) grants another
party (the franchisee) the right to operate a business under the franchisor's brand name and using the
franchisor's business model. The franchisee pays the franchisor a franchise fee and ongoing royalty
payments in exchange for the right to use the franchisor's brand and business system.

Joint venture: A joint venture is a business arrangement in which two or more parties agree to work
together to achieve a common goal. Joint ventures can be formed between businesses of all sizes, and
they can be used to enter new markets, develop new products or services, or expand existing
operations.

Social Enterprise: A social enterprise is a business that is designed to create social or environmental
impact alongside financial profit. Social enterprises use their profits to reinvest in their mission, rather
than paying out dividends to shareholders .Social enterprises can operate in any sector of the economy,
but they are often found in areas such as education, healthcare, and environmental protection.