Accounting principles and concepts

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

Learning objectives

By the end of this lesson, you should be able to:

• Define and apply key principles and concepts of accounting.

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 recognized 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 recognize income only because cash is received, and they don’t recognize expenses only because cash payment is made. Income is recognized when earned, and expenses are recognized 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.

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 by accounting standards. 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 accounts receivable and total accounts payable 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 judgment when outcomes are uncertain.

Definitions

Prudence concept

Involves the exercise of caution when making accounting judgments under uncertainty.

It requires accountants to make provision for all possible losses and not necessarily to anticipate profit. Profits should not be recognized until they are realized; however, a loss should be provided for (i.e., recognized) when there is sufficient evidence that losses will occur. This doesn’t override the goal of earning profit; it helps ensure that uncertainty is handled cautiously in financial reporting.

For example, provision for bad or 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.

We will explore this further in the next chapter.

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 (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.

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

The justification for this concept is to enable easy and direct assessment of performance or returns of the profitability arising from the capital 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.

Thus, assets and expenses are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of acquisition.

Liabilities and income, on the other hand, are recorded at the amount of proceeds received in exchange for the obligation. Current cost asserts that transactions be recorded at their present market value.

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 lease of machinery might be recorded as an asset purchase even if legally structured as a rental agreement in circumstances where the lessor substantially controls the asset without having legal ownership.