Accounting's Golden Rules: Assumptions, Principles & Conventions
Hello! Welcome to one of the most important chapters in accounting. Think of accounting as a language that businesses use to tell their story. For everyone to understand this story, there have to be rules – a shared grammar. This chapter is all about that grammar: the fundamental assumptions, principles, and conventions that all accountants follow.
Don't worry if the names sound complicated! We'll break them down with simple explanations and real-life examples. Understanding these rules is crucial because they ensure that financial statements are consistent, comparable, and reliable. Let's dive into the rulebook!
Part 1: The Core Assumptions (The Foundation of the House)
These are the basic beliefs that we accept as true without needing proof. They form the foundation on which all accounting is built.
1. Business Entity Concept
What it means:
The Business Entity concept states that a 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 apart.
Analogy: Think of your favourite local cafe. In the eyes of accounting, the cafe is one "person" and the owner is a completely different "person". They have separate wallets and bank accounts.
Why it's important:
This allows us to measure the true performance and financial position of the business itself, without the owner's personal transactions confusing the picture.
Real-World Example:
Mr. Wong owns a stationery shop. He takes $500 from the shop's cash register to pay for his family's dinner. Thanks to the business entity concept, this is NOT recorded as a business expense (like 'staff meals'). Instead, it's recorded as 'Drawings' – the owner taking money out of the business for personal use.
Shortcomings:
For sole proprietorships and partnerships, while accounting separates the business and owner, the law often doesn't. The owner is still personally liable for all business debts, which can be a bit confusing.
Key Takeaway:
Business money and owner's money must never mix!
2. Going Concern Concept
What it means:
The Going Concern assumption means we assume a business will continue to operate for the foreseeable future (at least the next 12 months) and has no intention or need to close down.
Analogy: We assume the business is running a marathon, not a 100-metre sprint. It plans to be around for the long haul.
Why it's important:
This assumption justifies many accounting practices, such as:
- Recording assets at their cost and depreciating them over their useful lives.
- Classifying assets and liabilities as 'current' (short-term) or 'non-current' (long-term).
Real-World Example:
A delivery company buys a new van for $300,000 that is expected to last for 5 years. Because of the going concern assumption, it doesn't record a $300,000 expense in Year 1. Instead, it records the van as a non-current asset and spreads its cost (depreciation) over the 5 years it will be used. This makes sense only if we assume the company will still be in business in Years 2, 3, 4, and 5.
Shortcomings:
This assumption might not be true if a business is facing severe financial trouble. In that case, financial statements prepared on a going concern basis could be misleading. Assets might need to be valued at their 'break-up value' (what they could be sold for quickly), which is often much lower than their cost.
Key Takeaway:
Assume the business will live on, unless there's evidence it won't.
3. Money Measurement Concept
What it means:
The Money Measurement concept states that accounting only records transactions and events that can be reasonably measured in monetary terms (e.g., Hong Kong Dollars).
Analogy: Accounting is a language that only understands numbers with a currency sign in front of them (like $, £, €). It can't understand things like 'happy staff' or 'great location'.
Why it's important:
It provides a common, simple unit of measurement to record a wide variety of business activities, making them easy to add, subtract, and analyse.
Real-World Example:
A software company has a team of brilliant programmers and a fantastic brand reputation. While these are incredibly valuable to the company, they cannot be measured in dollars, so they are not recorded as assets in the statement of financial position. However, the new computers they bought for $100,000 can be measured in money, so they are recorded.
Shortcomings:
This is a major limitation of accounting! It ignores very important non-monetary information like employee skill, customer loyalty, product quality, and management effectiveness. It also ignores the effects of inflation (e.g., $1,000 recorded 10 years ago is not the same value as $1,000 today).
Key Takeaway:
If you can't put a dollar value on it, it doesn't go in the main accounting records.
Part 2: The Key Principles (The Rules of the Game)
These are the specific rules accountants follow when recording and reporting transactions. They stem from the core assumptions.
4. Historical Cost Principle
What it means:
The Historical Cost principle requires that assets are recorded at their original purchase price (their 'historical' cost). This value is not changed even if the asset's market value increases or decreases over time.
Analogy: We record an asset's price based on its "birth certificate" (the purchase receipt). We don't update it for how much it's worth today.
Why it's important:
The original cost is objective and verifiable. We have a transaction, a receipt, or an invoice to prove it. Market values, on the other hand, can be subjective and change daily.
Real-World Example:
In 2010, a company bought an office building for $8 million. In 2024, due to the property market boom, the building is now worth $25 million. According to the historical cost principle, the building is still shown at $8 million (minus any accumulated depreciation) in the company's statement of financial position.
Shortcomings:
The statement of financial position may not reflect the true current worth of a company's assets, making it less relevant for some decisions. This is especially true during periods of high inflation.
Key Takeaway:
Record it at the price you paid for it.
5. Realisation Principle
What it means:
The Realisation principle dictates when a business should recognise (record) revenue. Revenue is realised when the goods or services have been delivered to the customer, and the business has earned the right to receive payment. The timing of cash receipt is not the most important factor.
Analogy: "Don't count your chickens before they hatch!" You only record the sale when you've done your part of the deal (e.g., handed over the product).
Why it's important:
It prevents businesses from inflating their profits by recording revenue too early, before it has actually been earned.
Real-World Example:
A furniture store receives an order and a $2,000 deposit for a sofa on 25th March. The sofa is delivered to the customer on 10th April, and the customer pays the remaining balance. The full revenue from the sale is recorded in April, not March, because that's when the sofa was delivered and the revenue was 'earned'.
Shortcomings:
Determining the exact point of realisation can be tricky for long-term contracts or services that are provided over a long period.
Key Takeaway:
Record revenue only when it's earned, not necessarily when cash is received.
6. Accrual and Matching Principles (The Perfect Pair)
These two principles work hand-in-hand and are the foundation of modern accounting. Don't worry if they seem tricky at first, they are a powerful team!
The Accrual Concept:
The Accrual concept states that revenues and expenses should be recorded in the accounting period in which they occur, regardless of when cash is actually paid or received. It's about the timing of the economic event.
Analogy: You mark an event on your calendar on the day it happens, not the day you paid for the ticket.
The Matching Principle:
The Matching principle is an application of the accrual concept. It states that expenses should be 'matched' with the revenues they helped to generate in the same accounting period.
Analogy: If you sell a cake, you should record the cost of the flour, sugar, and eggs (the expenses) in the very same period you record the revenue from selling the cake. This is the only way to know your true profit on that cake.
Why they are important:
Together, they provide a much more accurate picture of a company's profitability for a specific period (e.g., a month or a year) than just looking at cash movements.
Real-World Example:
A shop buys T-shirts for $50 each in January. In February, it sells one T-shirt for $120 on credit (the customer will pay in March).
- Following the Realisation Principle, the $120 revenue is recorded in February (when the sale was made).
- Following the Matching Principle, the $50 cost of that T-shirt (an expense called 'Cost of Goods Sold') is also recorded in February.
- This allows the shop to correctly calculate its gross profit for February as $$ $120 - $50 = $70 $$.
- The actual cash movements (paying for the T-shirt in January, receiving cash from the customer in March) are ignored for the purpose of calculating February's profit.
Shortcomings:
Accrual accounting is more complex than simple cash accounting. It can also be difficult to perfectly match some expenses (like the salary of the company's CEO) to specific revenues.
Key Takeaway:
Record revenues when earned and expenses when incurred, then match them together in the same period to find the true profit.
Part 3: The Modifying Conventions (Applying Judgement)
These are practical guidelines or customs that have been widely accepted. They help accountants deal with situations where the main principles might be too rigid.
8. Consistency Convention
What it means:
The Consistency convention means a business should use the same accounting methods and procedures from one period to the next. If a change is necessary, the reason for the change and its effect must be disclosed.
Analogy: If you measure your height, you should always use the same measuring tape (e.g., centimetres). You shouldn't switch to inches next month and then back to centimetres, as it would make it hard to track your growth.
Why it's important:
Consistency makes financial statements comparable over time. Users can analyse trends knowing that the figures have been calculated in the same way each year.
Real-World Example:
There are several methods to calculate depreciation (e.g., straight-line, reducing-balance). If a company chooses the straight-line method for its machinery, it must consistently use this method every year. It cannot switch to another method just to make its profits look better.
Shortcomings:
This convention might discourage a company from switching to a new, improved accounting method if one becomes available, as changing can be complex.
Key Takeaway:
Once you choose a method, stick with it!
9. Prudence (or Conservatism) Convention
What it means:
The Prudence convention suggests that when there is uncertainty, accountants should choose the treatment that is least likely to overstate assets or profits. It means you should anticipate and record potential losses, but only record gains when they are actually realised.
Analogy: "Hope for the best, but prepare for the worst." It’s a cautious approach.
Why it's important:
It helps ensure that financial statements are not overly optimistic or misleading to investors and creditors. It builds confidence by presenting a realistic (and slightly cautious) view.
Real-World Example:
A company's inventory of mobile phones cost $100,000. However, a new model has been released, and the company now expects to sell the old phones for only $80,000. Due to prudence, the company must immediately recognise a $20,000 loss and write down the value of the inventory to $80,000 in its records. Another example is creating an 'allowance for doubtful debts' for customers who might not pay what they owe.
Shortcomings:
If applied too aggressively, prudence can lead to the deliberate understatement of profits and assets, creating 'hidden reserves'. This can be just as misleading as being too optimistic.
Key Takeaway:
When in doubt, choose the cautious path that doesn't overstate your success.
10. Materiality Convention
What it means:
The Materiality convention states that a business only needs to strictly follow accounting principles for items that are 'material' – meaning, items that are large or important enough to influence the decisions of a user of the financial statements.
Analogy: "Don't sweat the small stuff." Focus your effort on the things that actually matter.
Why it's important:
It saves accountants a huge amount of time and effort. It keeps financial statements from being cluttered with tiny, insignificant details, making them easier to read and understand.
Real-World Example:
A large corporation like HSBC buys a wastepaper bin for $100. Technically, the bin is a non-current asset that will be used for several years. However, its cost is completely immaterial to a multi-billion dollar company. So, instead of depreciating it over 3 years, the accountant will just record the $100 as a simple 'stationery expense' for the period. This is a practical shortcut allowed by materiality. However, a $100,000 error in reporting profit would definitely be material!
Shortcomings:
Materiality is subjective. There is no magic number that makes something material. It depends on the size and nature of the business and requires professional judgement. What is immaterial to HSBC might be very material to a small corner shop.
Key Takeaway:
If it's too small to make a difference, you don't need to follow the rules so strictly.
Chapter Summary: The Big Picture
These ten concepts are the pillars that hold up the entire structure of accounting. They work together to ensure that the financial story a business tells is fair, understandable, and trustworthy.
Quick Review:
Business Entity: Keep business and personal separate.
Going Concern: Assume the business will continue.
Money Measurement: Only record what can be measured in money.
Historical Cost: Record assets at their original purchase price.
Realisation: Record revenue when it's earned.
Accrual: Record events when they happen, not when cash moves.
Matching: Match expenses to the revenue they helped create.
Consistency: Use the same methods every period.
Prudence: Be cautious and don't overstate profits or assets.
Materiality: Focus on what's important; ignore the tiny details.
Great job getting through these concepts! They might take a little while to sink in, so review them often. As you study more accounting topics, you will see these rules in action everywhere you look. Keep up the excellent work!