3.

Accounting Concepts used in

the Preparation of Accounting
Records

Name………………………………………
 ACCOUNTING CONCEPTS

Accountants are governed by rules and laws when preparing the final accounts of a business.
The rules are referred to as accounting concepts some are enshrined in law and in standards
(IAS’s, FRS’s and SSAP’s) laid down by major accounting bodies.

Concepts are a popular topic for questions in exams as they underpin all of the work done by
accountants.

THE GOING CONCERN CONCEPT

We assume that the business will continue to carry on trading for the foreseeable future. In
other words it is not expected that the business will close down or be sold. This concept
affects the way that assets are valued. For a going concern it is reasonable to value assets at
their COST price. This is the value that is most commonly used.

However if a business was expected to close down then the assets would be valued at the
amount that they could reasonable be sold for.

THE ACCRUALS CONCEPT (THE MATCHING CONCEPT)

The accrual concept states that revenue should be recognised when it is earned and not when
the money is received.

This can be illustrated by considering a business transaction in which goods are sold on
credit. Suppose the business sells the goods to a customer in December and receives payment
in the following March. Even though the payment is not received until March it should still be
recorded as revenue in December.

The same principal applies to purchases made by a business, net profit is the difference
between revenues and expenses i.e.

REVENUES – EXPENSES = NET PROFIT

The fact is that the profit is said to be the difference between revenues and expenses
not the difference between cash receipts and payments. This ensures that the accounts
of the business relate to what has happened during a period rather than the amount of cash
that has been received or paid.
PRUDENCE CONCEPT

The prudence concept states that accountants should be cautious when reporting the
financial position of a business.

It is therefore better to understate profits or the value of assets than to overstate

them.

It is prudent to choose valuations that will result in a lower figure for assets.

For example

A vehicle should be shown at the net book value after taking off depreciation, not the cost
price, similarly bad debts should be recorded immediately and debtors should be shown at the
net amount after taking off the provision for doubtful debts, therefore it should be valued
at the lower amount.

Profits should also not be anticipated by recording them before they are realised.

CONSISTENCY CONCEPT

The consistency concept states that the accounts of a business should be prepared on the
same basis every year.

Therefore once certain accounting methods have been adopted then the business should
continue to apply such methods consistently. Only then can meaningful comparisons be made
year on year.

For example a business decides to make a provision for depreciation at 10% straight line
method. It should continue to use that method and percentage for future assets. If a change
must be made, that has a material effect in the reports, the effect must be disclosed.

THE COST CONCEPT

Assets are normally shown at cost price and this is the basis for the valuation of the asset.
MATERIALITY

The effort of recording every trivial transactions in the accounts would be wasteful and
serve no useful purpose. Information is considered material if its omission from a financial
statement could be misleading.

The concept of materiality is particularly relevant when distinguishing between capital

expenditure and revenue expenditure. Capital expenditure is shown as an increase in the
businesses fixed assets on the balance sheet, Revenue expenditure is shown as an expense in
the profit and loss account. Under certain circumstances, the materiality concept states that
it is acceptable to treat some capital expenditure as revenue expenditure.

For example, a business may purchases a waste paper bin for £5.00. The bin has been
purchased with the intention to keep and use within the business and as such should be
recorded as capital expenditure.

However according to the materiality concept, it is acceptable to treat this as revenue

expenditure in the profit and loss account. This avoids cluttering the balance sheet with
trivial items.

The threshold of materiality will vary from item to item and company to company

THE BUSINESS ENTITY CONCEPT

The business entity concept states that the financial affairs of the business should be
completely separate from those of the owner.

The items recorded in a firm’s books are limited to the transactions that affect the firm as a
business entity. The records do not show the personal transactions of the owner.

The only time the personal resources of the proprietor affect the firm’s accounting records
is when the proprietor brings new capital into the firm or takes drawings out of the firm.

MONEY MEASUREMENT CONCEPT

The money measurement concept states that financial records including the value of
transactions, assets, liabilities and capital should be expressed in monetary terms.
This means that accounting can never tell you everything about a business. For example it
does not show the following:

1. Whether the firm has good or bad managers

2. That there are any serious problems with the workforce
3. That a rival product is about to take away many of its best customers
4. That the government is about to pass a law that will cost the business extra expense in
the future.

THE REALISATION CONCEPT

The realisation concept states that revenue should not be recognised until the exchange of
goods or services has taken place.

For example normally profit is said to be earned at the time when:

 Goods or services are passed to the customer, and
 He then incurs liability for them.

This concept of profit is known as the realisation concept. Notice that it is:
 Not when the order is received, and
 Not when the customer pays for the goods.


THE DUAL ASPECT CONCEPT

The dual aspect concept states that every transaction has two effects on a business’s
accounts. Double entry book-keeping. The concept states that these two aspects are always
equal.

In other words

ASSETS = CAPITAL + LIABILITIES

The foundation of which is the double entry of recording transactions.

NEW TERMS

ACCRUALS CONCEPT - Where net profit is the difference between revenues and
expenses.

BUSINESS ENTITY CONCEPT - Concerning only transactions which affect the firm, and
ignoring the owner’s private transactions.

CONSISTENCY - To keep the same method, except in special cases.

COST CONCEPT - Assets are normally shown at cost price.

DUALITY CONCEPT - Two aspects to every transaction.

GOING CONCERN CONCEPT - Where a business is assumed to continue for a long time.

MATERIALITY CONCEPT - Accountants should not spend time trying to record trivial
items as fixed assets but should instead treat them as revenue expenditure

MONEY MEASUREMENT CONCEPT - The concept that accounting is concerned only with
facts measureable in money, and for which a measurement can obtain general agreement.

PRUDENCE - To ensure that profit is not shown as being too high, or assets shown at too
high a value.

REALISATION CONCEPT - The point at which profit is treated as being earned.