Accounting principles and concepts

This chapter introduces the key concepts and principles of accounting, including going concern, accrual basis, materiality, prudence, duality, and business entity, alongside measurement bases. These concepts and principles guide how financial information is recorded and reported.

Going concern concept

Financial statements are prepared using certain underlying assumptions. One of the most important is the going concern assumption.

Definitions

Going concern concept

Assumes that the business has neither the need nor the intention to liquidate or curtail the scale of its operation.

In other words, the business is expected to keep operating for the foreseeable future, rather than shutting down.

This matters because it affects how assets are measured. When there are no going concern problems, asset balances are stated at their historical costs rather than their break-up value (the amount you might get if the business had to sell assets quickly).

Accounting standards require management to assess whether the entity can continue as a going concern when preparing financial statements. This assessment should consider the entity’s outlook for at least 12 months after the reporting period, but it’s not limited to that time frame.

Accrual accounting

Accrual accounting focuses on when income is earned, and expenses are incurred, not simply when cash moves.

Definitions

Accrual concept

Effects of transactions and events are recognised in the financial statements when they occur (not necessarily when cash or its equivalent is received or paid). Thus, transactions and events are recorded in the periods to which they relate.

So, financial statements don’t recognise income only because cash is received, and they don’t recognise expenses only because cash payment is made. Income is recognised when earned, and expenses are recognised when incurred.

When determining profit, expenses incurred (i.e., either paid or unpaid) should be matched against the revenues earned (i.e., either received or not). This is referred to as the matching concept. The matching concept is integral to the accrual basis.

Materiality

Not all information carries the same weight for users of financial statements. The materiality concept helps determine what needs to be reported, and how.

Definitions

Materiality concept

Information is material if omitting, misstating, or obscuring it could reasonably be expected to influence the decisions that primary users make based on the financial statements. Materiality depends on the nature and/or size of the item, and is judged relative to the entity’s own circumstances.

For example, a business might expense a $20 stapler immediately rather than capitalising it as a non-current asset and depreciating it over time, since the amount is too small to affect any user’s decisions.

Offsetting

In general, financial statements show items separately rather than netting them off.

Definitions

The offsetting principle

Asserts that assets and liabilities, or income and expenses, should not be offset unless required or permitted by an IFRS Accounting Standard. Thus, items should be reported separately, not netted against each other.

For example, where the business owes an individual (i.e., payables), and the same individual also owes the business (i.e., receivables), the total receivables and total payables are presented separately, not the net difference.

Consistency

Consistency helps users compare financial statements across time and, in some cases, across entities.

Definitions

Consistency principle

Refers to the use of the same method(s) for the same items, either from period to period within a reporting entity or in a single period across entities.

Using the same methods supports comparability of financial statements over time, making it easier to identify trends and performance patterns.

A change in method is allowable only under any of these circumstances:

• The change is required by IFRS (i.e., where a new accounting standard or interpretation is issued for the item)
• The change will result in financial statements that are reliable and more relevant

When a change is made, the new policy must then be applied consistently for comparability purposes.

Prudence

Prudence is about careful judgement when outcomes are uncertain.

Definitions

Prudence concept

The exercise of caution when making accounting judgements under conditions of uncertainty, so that assets and income are not overstated and liabilities and expenses are not understated. Equally, prudence does not permit the deliberate understatement of assets or income, or overstatement of liabilities or expenses.

In practice, this means taking care not to overstate assets or income, or understate liabilities or expenses, when estimates are uncertain. Under the Conceptual Framework, prudence does not require gains and losses to be treated differently: a gain can be recognised before it is realised in cash, such as a revaluation surplus. This doesn’t override the goal of earning profit; it helps ensure that uncertainty is handled cautiously in financial reporting, without creating hidden reserves.

For example, an allowance for irrecoverable (doubtful) debts is an application of the prudence concept.

Duality

Duality explains why every transaction affects at least two accounts.

Definitions

Duality concept

Asserts that every transaction has two equal and opposite effects, being the debit and credit sides of two different ledger accounts.

At a minimum, every transaction has one receiving side and one giving side. This forms the basis for postings into ledger accounts, the summary of transactions in the trial balance, and finally, the preparation of the financial statements.

For example, purchasing inventory increases inventory (asset) and decreases cash (asset). Cash decreases because it is used for payment, while inventory increases because it is what is acquired.

Business entity

The business entity concept separates the business from its owners for accounting purposes.

Definitions

Business entity concept

Asserts and sees businesses to be separate and distinct from their owners (whether sole traders, partners, or shareholders).

When preparing the accounts of a business entity, personal transactions (e.g., income and expenditures) of the owners should not be mixed with those of the business. Amounts an owner withdraws for personal use are recorded as drawings, which reduce the owner’s capital, rather than as a business expense.

For example, an owner’s personal car expenses shouldn’t be recorded in business accounts unless used for business purposes.

This lets users assess the business’s own performance and the return on the capital the owners have invested.

Historical cost and current value

These two concepts represent different measurement bases for elements of the financial statements. Historical cost asserts that transactions be recorded at their original cost.

Under historical cost, assets are recorded at the cash or cash equivalents paid, or the fair value of the consideration given, to acquire them at the time of acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation.

Current value updates these measurements to reflect conditions at the reporting date. Examples include fair value (the price to sell an asset, or transfer a liability, in an orderly transaction between market participants) and current cost (the cost of an equivalent asset today).

Most assets are recorded at historical cost, but some require measurement at current value.

Substance over form

Sometimes the legal structure of a transaction doesn’t fully reflect what is happening economically.

Definitions

Substance over form concept

Asserts that transactions should be recorded based on their economic reality rather than just legal form.

This means you focus on the underlying economic substance of transactions.

For example, a lessee may record leased machinery as an asset, even though the lease is legally a rental agreement, because the lessee controls the asset and gets substantially all its benefits without having legal ownership.