BAFS Study Notes: Accounting Assumptions, Principles and Conventions
Hey everyone! Welcome to your study notes for a super important topic: Accounting Assumptions, Principles, and Conventions. Don't worry if the name sounds a bit formal. Think of these as the 'rules of the game' for accounting. Just like you need rules in football to make sure everyone plays fairly and the score is accurate, accountants need rules to make sure a company's financial information is reliable, consistent, and easy to understand.
In this chapter, we'll break down the 10 fundamental rules that every accountant follows. Understanding these will help you make sense of all the financial statements you'll see in BAFS. You've got this!
First, a Quick Refresher on Key Terms
Before we dive in, let's remember a few basic terms:
- Assets: Things the business owns (e.g., cash, inventory, machines).
- Liabilities: What the business owes to others (e.g., loans, money owed to suppliers).
- Revenue: Money the business earns from selling goods or services.
- Expenses: Costs of running the business (e.g., rent, salaries, electricity).
The Core Rules of Accounting
We can group these 10 rules into three categories: Fundamental Assumptions, Key Principles, and Modifying Conventions. Let's go through them one by one!
Part 1: Fundamental Assumptions (The Bedrock Ideas)
These are the basic ideas that we assume are true when we prepare financial statements.
1. The Business Entity Concept
What it means: The business is treated as a completely separate entity from its owner(s). The business's finances and the owner's personal finances must be kept separate.
In Simple Words: The business has its own "wallet," and the owner has their own personal wallet. They should never be mixed up!
Real-World Analogy: Imagine you own a small bubble tea shop. The money in the shop's cash register belongs to the shop. The money in your personal wallet belongs to you. If you take $100 from the cash register to buy yourself a new pair of shoes, you can't record it as a business expense like 'shoe supplies'. It's a personal transaction and must be recorded as 'drawings' (owner taking money out).
Why is it Important? It allows us to accurately measure the performance (profit or loss) of the business itself, without personal transactions confusing the picture.
Shortcomings: For sole proprietorships and partnerships, this is an accounting separation, not a legal one. If the business goes into debt, the owner's personal assets can still be used to pay it off.
Key Takeaway: Business money and personal money are separate. Period.
2. The Going Concern Concept
What it means: We assume that the business will continue to operate for the foreseeable future and has no intention of closing down or significantly scaling back its operations.
In Simple Words: We assume the business isn't going to shut down anytime soon.
Real-World Analogy: When you buy a textbook for school, you assume you'll be using it for the whole year, not just for one day. Similarly, when a company buys a delivery van, it records it as a long-term asset, assuming the business will be around long enough to get the full benefit from it.
Why is it Important? This assumption allows us to record long-term assets (like buildings and machinery) at their cost and spread that cost over many years (this is called depreciation). If we thought the business was closing tomorrow, we'd have to value everything at its immediate sale price, which would be much lower.
Shortcomings: If a business is in serious financial trouble, this assumption may not be valid, and the financial statements would need to be prepared on a different basis (a 'break-up basis').
Key Takeaway: Assume the business will last. This justifies valuing assets at cost, not their immediate "sell-now" price.
3. The Money Measurement Concept
What it means: Only transactions and events that can be expressed in terms of money are recorded in the accounting books. All transactions are recorded in a single, stable monetary unit (e.g., Hong Kong Dollars).
In Simple Words: If you can't put a dollar value on it, it doesn't go in the accounting records.
Example: A company can record the salary paid to its talented manager ($50,000 per month). However, it cannot record the manager's excellent leadership skills or the high morale of the staff, even though these things are very valuable to the company.
Why is it Important? It provides a common unit of measurement (like centimetres for length) so that different items can be added together and summarised in financial reports.
Shortcomings: It ignores important non-monetary factors like staff morale, product quality, and customer satisfaction. It also ignores the effect of inflation (a dollar today is worth more than a dollar in five years).
Key Takeaway: In accounting, money talks. Everything else is ignored.
Part 2: Key Principles (The Main Rules for Recording)
These principles guide how we record the transactions we've identified.
4. The Historical Cost Principle
What it means: Assets are recorded in the accounting records at the price they were paid for at the time of purchase. This value is not changed, even if the market value of the asset changes later.
In Simple Words: We record what we paid for it, not what it's worth today.
Example: A company buys an office building for $10 million in 2010. By 2024, the property market has boomed, and the building is now worth $25 million. According to the historical cost principle, the company must continue to list the building in its financial statements at the original cost of $10 million.
Why is it Important? The original cost is a verifiable, objective fact (it's on the receipt!). Market values can change daily and are subjective, making them less reliable.
Shortcomings: The financial statements might not show the true current value of the business's assets, especially for things like land and buildings that can increase in value significantly.
Key Takeaway: The price on the original receipt is the price that stays in the books.
5. The Accrual Concept
What it means: Revenue is recognised when it is earned, and expenses are recognised when they are incurred, regardless of when the cash is actually received or paid.
In Simple Words: Record transactions when they happen, not when the cash moves.
Example: A tutoring centre provides lessons to a student in December. The student agrees to pay the $2,000 fee in January. The accrual concept says the centre should record the $2,000 revenue in December (when the lessons were given and the revenue was earned), not in January (when the cash was received).
Why is it Important? It gives a much more accurate picture of a company's financial performance in a specific period.
Shortcomings: It can be more complex than simple cash accounting.
Key Takeaway: Timing is about earning/incurring, not paying/receiving cash.
6. The Matching Principle
What it means: This principle is closely related to the accrual concept. It states that the expenses incurred to generate revenue should be recorded in the same accounting period as that revenue.
In Simple Words: Match the costs with the income they helped to create.
Example: A shop buys a phone for $3,000 in November. It sells that same phone for $5,000 in December. The $3,000 cost (expense) should be recorded in December to be 'matched' against the $5,000 revenue it helped to generate. This shows the true profit ($2,000) from the sale in December.
Why is it Important? It prevents costs from being recorded in the wrong period, which would distort the company's profit for that period.
Shortcomings: It can sometimes be difficult to directly link certain expenses (like advertising) to specific revenues.
Key Takeaway: Report revenue and its related expenses in the same period to calculate true profit.
7. The Realisation Principle
What it means: Revenue should only be recognised (recorded) when the goods or services have been delivered to the customer and the customer is legally obligated to pay for them.
In Simple Words: Don't count your chickens before they hatch. Only record revenue when the sale is official.
Example: A customer places an order for a custom-made cake on Monday and pays a deposit. You bake the cake on Tuesday. The customer picks it up and pays the balance on Wednesday. According to the realisation principle, the revenue is 'realised' and should be recorded on Wednesday, when the sale process is complete.
Why is it Important? It prevents companies from recording revenue too early, which would overstate their profits.
Shortcomings: For long-term projects (like building a skyscraper), it can be complex to decide exactly when revenue is realised.
Key Takeaway: Record revenue only when the job is done and the money is legally yours (even if not yet in your hand).
Part 3: Modifying Conventions (The Practical "But..." Rules)
These conventions help accountants apply the principles in a practical, sensible way.
8. The Consistency Convention
What it means: A business should use the same accounting methods and procedures from one period to the next. If a change is necessary, it must be disclosed in the financial statements.
In Simple Words: Once you pick a way to do something, stick with it.
Example: There are different ways to calculate depreciation. A company might choose the 'straight-line method'. The consistency convention says they should continue using the straight-line method every year. They shouldn't switch to a different method next year just because it makes their profit look better.
Why is it Important? It allows for meaningful comparison of a company's financial statements over time. If they kept changing the rules, you couldn't tell if the company was actually performing better or just using different accounting tricks.
Shortcomings: It might prevent a company from switching to a new, better accounting method if one is developed.
Key Takeaway: Don't change the rules of the game halfway through. Be consistent.
9. The Prudence Convention (also known as Conservatism)
What it means: When there is uncertainty, accountants should choose the method that is least likely to overstate assets and profits or understate liabilities and losses.
In Simple Words: When in doubt, play it safe. Anticipate losses, but don't anticipate profits.
Real-World Analogy: When you're saving for a trip, you might budget for the highest possible flight price you've seen. You are being prudent. You don't budget for the lowest fantasy price that might not exist.
Example: A business has some inventory (stock) that cost $5,000. Due to a new trend, they now think they can only sell it for $4,000. Prudence requires them to immediately recognise a potential loss and record the inventory at the lower value of $4,000. On the other hand, if they thought its value had gone up to $6,000, they would still keep it at the cost of $5,000 until it is actually sold.
Why is it Important? It ensures that the financial statements present a realistic and cautious view of the company's financial position.
Shortcomings: If applied too aggressively, it can lead to deliberately understating profits and assets, making the financial statements less accurate.
Key Takeaway: Be realistic and cautious. Record expected losses now, but only record profits when they actually happen.
10. The Materiality Convention
What it means: Accountants should focus on items and information that are significant enough to affect the decisions of users of the financial statements. Minor or trivial items can be treated in the most convenient way.
In Simple Words: Don't sweat the small stuff, but pay very close attention to the big stuff.
Example: A large company like MTR buys a stapler for $50. The stapler will last for many years, so technically it's a long-term asset. But a $50 item is completely insignificant (immaterial) for a multi-billion dollar company. Materiality allows the accountant to just record the $50 as a simple 'office expense' for the current year, instead of going through the complicated process of depreciating it. However, a brand new train costing $50 million is very material and must be recorded properly as a long-term asset.
Why is it Important? It keeps accounting practical and prevents financial statements from being cluttered with tiny, unimportant details.
Shortcomings: It is subjective. What is material for a small shop is immaterial for a huge corporation. It requires professional judgment.
Key Takeaway: If it's big enough to matter to an investor, record it perfectly. If it's not, use a simpler method.
Putting It All Together: Application Scenarios
Let's see if you can spot the principle or convention in action!
Scenario 1: The owner of a small shop, Ken, uses the shop's money to pay for his son's school fees. He records this as 'Education Expense' in the shop's books.
Which concept did Ken violate? He violated the Business Entity concept by mixing his personal expenses with the business's expenses.
Scenario 2: ABC Ltd bought a machine for $100,000. One year later, they find out they could sell it for $120,000. They continue to show it in their records at $100,000.
Which principle are they following? They are correctly following the Historical Cost principle.
Scenario 3: A company provides a service in June and sends the bill to the client. The client pays in July. The company records the revenue in June.
Which concept justifies this? The Accrual (and Realisation) concept. The revenue was earned in June, so it should be recorded in June.
Scenario 4: A company accountant isn't sure if a customer with a large debt will pay them back. The accountant decides to create an 'allowance for doubtful debts' to recognise a potential loss.
Which convention is being applied? The Prudence convention. They are anticipating a potential loss and recording it.
Great job getting through all of that! These 10 concepts are the foundation of everything we do in accounting. Review them, understand the examples, and you'll be in a fantastic position for the rest of your BAFS journey. Keep up the great work!