📚 Accounting Concepts: The Rules of the Game 🎮
Welcome to this crucial chapter! Preparing financial statements (like the Statement of Profit or Loss and the Statement of Financial Position) isn't just about adding up numbers. It’s about following a strict set of rules, or Accounting Concepts.
Think of these concepts like the rules of a major board game. If everyone follows them, the game is fair, understandable, and the final results (your financial statements) are accurate and comparable. Understanding these rules is essential for preparing financial statements correctly!
Why Do We Need Accounting Concepts?
We use accounting concepts to ensure that financial information is reliable, comparable (you can compare this year to last year), and understandable to everyone reading the report, including managers, owners, and bankers.
1. The Business Entity Concept
What does it mean?
The Business Entity Concept states that the business must be treated as completely separate from its owner (or owners).
Analogy: Imagine your local bakery. The business is one person (or 'entity'), and the baker (the owner) is a completely separate person. Even if the baker owns 100% of the shop, their personal finances must be kept separate from the shop’s finances.
How this applies in preparation:
- If the owner takes money out of the business for personal use (like paying their electricity bill at home), we record this as Drawings. Drawings are a reduction in Capital, not a business expense.
- If the owner introduces their own cash or assets into the business, we record this as an increase in Capital (Owner's Equity).
Key Takeaway: Never mix business transactions with personal transactions. If you break this rule, you cannot accurately calculate the profit the business has made.
2. The Money Measurement Concept
What does it mean?
The Money Measurement Concept states that accounting records will only include items that can be expressed in terms of money (e.g., US Dollars, British Pounds, etc.).
Example: We record the cost of a new delivery van (\$20,000) because that is a monetary value.
How this applies in preparation:
- We cannot record crucial, but non-monetary, aspects of the business, such as the fantastic skill of the manager, the loyalty of the customers, or a great relationship with suppliers.
- All transactions must be recorded using a stable currency. This allows us to add up different items (like machinery and inventory).
Common Mistake to Avoid: Don't confuse importance with measurement. A happy workforce is vital, but since you can’t put a precise monetary value on 'happiness' for the financial statements, it is excluded from the accounts.
✅ Quick Review
Business Entity: Separate the owner from the shop.
Money Measurement: Only things you can put a price tag on.
3. The Going Concern Concept
What does it mean?
The Going Concern Concept assumes that the business will continue to operate for the foreseeable future, rather than being closed down or sold off.
How this applies in preparation:
This concept is vital because it determines how we value assets, especially Non-current Assets (like machinery and buildings).
- If we assume the business is a Going Concern, we value assets based on their use in the business (Historical Cost minus depreciation).
- If we thought the business was closing down (not a Going Concern), we would have to value the assets at their immediate break-up value (what we could get for them right now if we sold them quickly). This would make the financial statements look completely different.
Memory Aid: "Going Concern means the company is Going and Operating On Normally."
4. The Historical Cost Concept
What does it mean?
The Historical Cost Concept requires us to record assets and expenses at their original purchase price (the cost at the time of the transaction).
How this applies in preparation:
This is one of the most practical and important rules, especially for Non-current Assets.
- If a machine cost $5,000 ten years ago, we record its original cost as $5,000, even if its current market value has increased to $10,000.
- We use this concept because the original cost is objective (based on a verifiable invoice) and not based on a subjective guess of the current market value.
Did you know? While we start with the Historical Cost, we then reduce the value of Non-current Assets each year using depreciation, to reflect the wear and tear and usage of the asset over time.
Key Takeaway: Accounts are based on what you paid, not what the item is currently worth.
5. The Duality Concept (The Core of Double-Entry)
What does it mean?
The Duality Concept (also known as the Double-Entry Concept) is the foundation of all accounting. It states that every financial transaction has at least two effects on the business.
It ensures that the fundamental Accounting Equation always balances:
\[
\text{Assets} = \text{Capital} + \text{Liabilities}
\]
How this applies in preparation:
This concept dictates how we use Debit and Credit entries:
-
When the business buys inventory for cash:
- Effect 1: Inventory (Asset) increases (Debit).
- Effect 2: Cash/Bank (Asset) decreases (Credit).
-
When the business takes out a bank loan:
- Effect 1: Bank (Asset) increases (Debit).
- Effect 2: Bank Loan (Liability) increases (Credit).
Memory Aid: Duality means "Two Sides." The Debits must always equal the Credits in your Trial Balance, confirming the Duality Concept has been followed.
6. The Prudence (or Conservatism) Concept
What does it mean?
The Prudence Concept (sometimes called Conservatism) requires accountants to be cautious when making judgments, especially when there is uncertainty.
How this applies in preparation:
In simple terms: Do not overstate profits or assets.
- Anticipate losses: Record expected future losses or expenses immediately. (Example: If you think a customer won't pay you, you should create an allowance for doubtful debts now.)
- Do not anticipate gains: Only record revenues or profits when they are certain to be received.
- Valuation Rule: When valuing inventory, use the lower of cost and net realisable value. This ensures we don't overstate the value of stock.
This concept protects the reader of the financial statements by making sure the company's financial health is presented realistically, not optimistically.
🔬 Final Summary of Core Concepts
Remember these six concepts are the foundations upon which all your financial statements are built. Get these concepts right, and your preparation work will be much clearer!
| Concept | The Simple Rule |
| Business Entity | Keep the owner’s cash separate from the business’s cash. |
| Money Measurement | Only record things that have a currency value. |
| Going Concern | Assume the business will continue operating indefinitely. |
| Historical Cost | Record assets at their original purchase price (cost). |
| Duality | Every transaction affects at least two accounts (Double-Entry). |
| Prudence | Be cautious; anticipate losses, but only record certain gains. |
Don't worry if these seem tricky at first! As you start practicing journal entries and statement preparation, you will be applying these rules automatically. Keep practicing!