Principles and concepts of accounting

For the purposes of the FA2 exam, there is a list of principles and concepts of accounting which you
need to be familiar with and which can be found in learning outcome A1(a) in the study guide:
 Going concern
 Accrual basis
 Materiality
 Consistency
 Prudence
 Duality (dual aspect)
 Business entity
 Historical cost
What candidates need to know about each of these is:
1. how it is defined, and
2. how it should be applied.
Each of these principles and concepts are considered below. Where a formal definition is provided
by the Conceptual Framework for Financial Reporting (the Conceptual Framework), that definition
is given, followed by an elaboration of the key points of that definition that candidates need to
understand.

Going concern
Definition: ‘Financial statements are normally prepared on the assumption that the reporting entity
is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed
that the entity has neither the intention nor the need to enter liquidation or to cease trading. If such
an intention or need exists, the financial statements may have to be prepared on a different basis. If
so, the financial statements describe the basis used.
The basic point about the going concern principle is that it is assumed that the entity will continue
to operate for the foreseeable future. For FA2, candidates do not need to consider the time period
that might be regarded as the ‘foreseeable future’. This is an advanced issue that will be considered
in later exams. The same can be said of issues such as:
 circumstances in which the going concern assumption might not apply;
 what different basis could be used; and
 who decides whether the going concern assumption should apply.
While an awareness of what is meant by ‘a different basis’ might be expected (for example, break
up basis), candidates would not be expected to apply that basis to calculate values in the FA2 exam.

Accrual basis
The Conceptual Framework refers to ‘accrual accounting’, also known as ‘the accruals concept’ or
simply as ‘accruals.’
Definition: ‘Accrual accounting depicts the effects of transactions and other events and
circumstances on a reporting entity’s economic resources and claims in the periods in which those
effects occur, even if the resulting cash receipts and payments occur in a different period.’
Essentially, what accrual accounting means is that the date on which cash is paid or received
is often not necessarily the same as the date that the actual transaction takes place, but this should
not delay the transaction being recorded. In transactions between businesses, it is common for
payment not to be made on the same date that an order is made or that goods are transferred.
Although the definition might seem a little complicated at first reading, this is essentially a simple
idea. If Andrea agrees to buy goods from Brian on 25 January and Brian agrees that Andrea can
wait until 25 March to actually pay for the goods, accrual accounting requires that the transaction is
recorded when the sale/purchase takes place rather than when cash changes hands. Thus, the initial
sale and purchase transaction is recorded on 25 January.
Accrual accounting means that the accounting records will include balances for receivables
(amounts that the entity expects to receive in the future as a result of past transactions) and payables
(amounts that the entity expects to pay out in the future as a result of past transactions). When
preparing financial statements, it will be necessary to recognise any costs that have been paid, but
not yet consumed (prepaid expenses), as well as costs that have been consumed, but not yet paid for
(accrued expenses).
It is worth remembering that, while a number of the theoretical aspects of the syllabus are linked in
the same way as has been noted above, candidates should ensure that they understand the key points
of each principle or concept in isolation first of all. Once a good understanding has been developed
at an individual level, it will be easier to make the links between the various principles and
concepts.

Materiality
Definition: ‘Information is material if omitting, misstating or obscuring it could reasonably be
expected to influence decisions that the primary users of general purpose financial reports make on
the basis of those reports, which provide financial information about a specific reporting entity.’
There are some key issues within this definition that candidates should be aware of.
The first is that materiality is different to complete accuracy. For example, we can see this in
practice in the published financial statements of large businesses. These often report values in $000
or $m. While the exact values to the single dollar are not communicated, the essential (material)
information is provided as an aid to decision making.
This leads to the second issue – materiality is related to the fact that the purpose of financial
statements is to provide information so that it can be used to make decisions about whether to
undertake transactions with a particular entity. So reporting to the nearest $000 or $m instead of the
nearest $, will often still allow informed decisions to be made.
The final issue is that materiality is affected by both:
1. whether information is included or omitted from financial statements, and
2. whether it is sufficiently informative.
It is not necessary, and often not helpful, to simply include as much detail as possible in the
financial statements. Consideration should be given to the fact that excessive detail may not actually
improve presentation and therefore not assist users of financial statements. For example, important
information could be obscured by including it among large amounts of insignificant detail.
Candidates in FA2 will not be required to decide on an appropriate cut off level for materiality. This
is a more advanced issue, which requires the exercise of professional judgment.

Consistency
Definition: ‘The use of the same methods for the same items, either from period to period within a
reporting entity or in a single period across entities.’
Consistency is a straightforward principle and is intended to enhance financial reporting by making
it easier for users to make comparisons. In that sense it contributes to the achievement of
comparability which is one of the qualitative characteristics of useful financial information (see the
related article ‘Qualitative accounting characteristics’).
By requiring similar items to be treated in the same way, this contributes to making comparisons
more meaningful.
Consistency should be applied in two ways:
1. ‘from period to period’ – ie by a single entity, and
2. ‘across entities’ – ie between entities in the same period.
In practical terms, this means that consistency helps to achieve comparability. For instance, it
should be possible for users to understand how a business has performed in the year by comparing it
to the results of the previous year. This is only possible if the figures and information are prepared
using consistent methods across each year. Consistency across entities means that it should be
possible to compare one business’s performance with a competitor and therefore make informed
investment decisions.
This does not mean that everything in the accounts needs to be treated the same by every entity.

Prudence
Definition: ‘The exercise of caution when making judgements under conditions of uncertainty. The
exercise of prudence means that assets and income are not overstated and liabilities and expenses
are not understated. Equally, the exercise of prudence does not allow for the understatement of
assets or income or the overstatement of liabilities or expenses.’
There is often uncertainty about the eventual outcome of certain events and transactions. This
means that estimates need to be made when preparing financial statements. Prudence requires that,
whenever such uncertainty exists, preparers of financial statements take a careful approach to the
figures and information that they include in the financial statements.
Arguably, the biggest risk in this regard is that a business will be inclined to be optimistic about
results and therefore overstate assets and income or understate liabilities and expenses. There could
be financial incentives for business owners to do this and therefore the prudence principle must be
observed to ensure this does not happen.
Equally, preparers should not be ‘overly prudent’ to the extent that they pick the lowest possible
outcome simply to avoid the risk of overstating assets and income or understating liabilities and
expenses. This would still not provide a fair presentation of the financial position or financial
performance of the entity and, therefore, it is important that caution is exercised to avoid this as
well.
Duality (dual aspect)
‘Duality’ refers to the fact that every transaction has a ‘dual aspect’ and therefore requires the use of
‘double entry’ accounting. Double entry is often easier to do than to explain. For this reason,
candidates would be wise to complete as many practice questions as possible before taking the
exam. It is also the reason why the topic can only be touched on briefly in a short article such as
this.
There is no definition of double entry in the Conceptual Framework – although it is probably fair to
say that this is the most fundamental underpinning principle in accounting. In the absence of a
formal definition, it is best to start by understanding the term ‘dual aspect’. The dual aspect means
that each party in a transaction is affected in two ways by the transaction and that every transaction
gives rise to both a debit entry (Dr) and a credit entry (Cr).
Given that the value of the debit entries is the same as the value of the credit entries for any given
transaction, it follows that when a number of transactions have been recorded, the total value of the
debit entries will still be the same as the total value of the credit entries. This is the basis of the
accounting equation.
All of this can be explained by considering the transaction that was included in the discussion on
accruals. This was that Andrea agrees to buy goods from Brian on 25 January and Brian agrees that
Andrea can wait until 25 March to pay for the goods.
This straightforward example allows a key point about double entry to be made. Clearly there are
two parties involved in the transaction. While both parties will record the transaction, that
is not what is meant by double entry. It is important to remember that when preparing accounting
entries, we are only dealing with a single entity – either Andrea or Brian.
From Andrea’s point of view the dual aspect is:
 she has obtained goods, and
 she has also incurred the responsibility to pay for the goods at a later date.
In a real-life situation (and in an exam question), it will be clear whether the goods have been
bought with the intention of selling them at a profit, or if they have been bought for
consumption/use within the business. For the moment, let’s assume that Andrea has bought the
goods for resale. That means we can now identify the two accounts in which entries will be made:
 goods for resale (or ‘purchases’ as is more often used to describe this account), and
 trade payables.
The next step is to decide which account will have the debit entry and which will have the credit
entry. One way of doing this is to use a memory AID. The upper-case letters have been used
because the word itself is the AID – Asset Increase Debit.
This AID reminds us that, if an asset has been increased, then a debit entry is required. The AID can
be expanded by changing one element within it at a time to the opposite state, leading to the
opposite entry:
Asset decreased Credit
Liability increased Credit

It can therefore be deduced that:

Liability decreased Debit

Using this logical approach, it should be possible to identify which accounts will be affected and
then consider how they will be affected.
Thus, if Andrea has incurred the responsibility to pay for the goods, she has clearly increased a
liability. That means a credit entry is required in her trade payables account. It follows that the entry
in her purchases account will be a debit.

Business entity
The business entity principle simply means that, for the purpose of maintaining accounting records,
the business is treated as a separate entity from the owner(s) of the business. The Conceptual
Framework refers to a ‘reporting entity’ which is an entity that is required, or chooses, to prepare
financial statements.
As FA2 only relates to unincorporated businesses (sole traders and partnerships), this might seem
like an unrealistic differentiation. However, a business entity is not necessarily a separate legal
entity and candidates should simply deal with transactions from the perspective of the business.
In our example, Andrea has been identified as the owner of the business. As she is a sole trader (ie
her business is unincorporated), there are some important legal points to be noted. The first is that
there is no legal differentiation between Andrea and her business. Following from that, Andrea will
be personally responsible for any debts that the business incurs, and her personal assets may be used
to settle business debts.
However, her personal assets are not included in the business records. In addition, if Andrea
withdraws money for personal expenses, the nature of the expense is not recorded. All that is
necessary is to record the fact that Andrea withdrew funds – with a debit entry in the drawings
account and credit entry in the bank account.

Historical cost
Theoretically, there are a number of bases that could be used to derive the value at which
transactions are recorded. However, historical cost is the only one of these that needs to be
considered in the context of FA2.
Definition: ‘Historical cost measures provide monetary information about assets, liabilities and
related income and expenses, using information derived, at least in part, from the price of the
transaction or other event that gave rise to them.’
In simple terms this means that, for FA2, assets and liabilities will continue to be recorded at the
value at which they were initially recorded and that value will be based on the value at the date of
the transaction.
The historical cost of assets and liabilities will still be updated over time to depict accounting
transactions like depreciation or the fulfilment of part or all of a liability. But it will not be updated
to reflect the current value of a similar asset or liability which might be acquired or taken on.

Summary
By ensuring that the key points of each of these principles and concepts are understood, candidates
should be better prepared to answer questions that might arise in the exam.