Bookkeeping concerns primarily with the recording of transactions in the books of accounts. The recording is based on certain assumptions. These assumptions are known as accounting concepts.
Underlying Accounting Concepts
A series of accounting concepts have been applied since the financial statements were produced for the first time for external reporting purposes.
The Historical Cost Concept
This means that assets are normally shown at cost, and this is the basis for the valuation of assets.
The Money Measurement Concept
Accounting information that traditionally has only been concerned with these events covered by (a) and (b) as follows:
(a) it can be measured in monetary units,
(b) most people will agree with the monetary value of the transaction.
This limitation refers to the money measurement concept, and means that accounting cannot tell you everything about a business. For example, accounting does not show the following:
(c) if the company is good or bad managers
(d) if there are serious problems with labor
(e) if a rival producer is about to bring many of the best clients
(f) if the government is about to pass a law that will cost the company a lot of additional expenses in the future.
The Business Entity Concept
The business entity concept implies that the affairs of a company must be treated as being separate from the non-commercial activities of its owners.
Items recorded in the books of the company are, therefore, limited to business transactions. No matter what activities the owners get up off the company, these are not accounted for in the books maintained by the business.
The only time the personal resources of the owners affect the accounting records of a company is when they introduce new capital into the business, or take drawings.
The Dual Aspect Concept
This indicates that there are two aspects of accounting, one represented by the assets of the company and the other for claims against them. The concept states that these two aspects are always equal. In other words, this is the alternative form of the accounting equation.
Therefore double entry is the name given to the method of recording transactions under the dual aspect concept.
The Time Interval Concept
One of the underlying principles of accounting, the time interval concept, is that financial statements (Income Statement, Balance Sheet, Cash Flow Statement etc) are prepared at regular intervals of one year. For internal management purposes they may be prepared for more frequently, possibly on a monthly basis or even more frequently.
Fundamental Accounting Concepts
These include a set of concepts considered so important that they have applied through accounting standards or by the Companies Acts. Five have been forced by the Companies Act 1985 and sixth through an accounting standard FRS 5 (Reporting the substance of the transaction).
The going concern concept implies that the business will continue to operate for the foreseeable future. Therefore, if there is no going concern problem, it is considered sensible to keep to the use of the historical cost concept when arriving at the valuation of assets. But if it is known, however, that the business will be forced to close down in near future then going concern assumption should be rejected and assets should not be shown in balance sheet at historical cost. To better understand this, let’s take an example:
Suppose that a business is drawing up its financial statements at 31 December 20X5. Normally, using the historical cost concept, the assets would be shown at a total value of $90,000. Now its know that the business is going to shut down in February 20X6, only two months later, and the assets are expected to be sold for only $20,000. In this case it would not make sense to keep to the going concern concept, and so we can reject the historical cost concept for asset valuation purposes. Therefore, in the balance sheet at 3 December 20X5 the assets will be shown at the value of $20,000.
The consistency concept says that when a business has once fixed a method for accounting treatment of an item, it will enter all similar items that follow in exactly the same way. However, this does not mean that the company has to follow the method until the business is closed. A company may change the method used, but this change is not made without much consideration. When a change occurs, and the benefits calculated in that year are affected by a material amount then either in the income statement itself or in any of the reports that accompany it, the effect of the change should be indicated.
The accountant should always be careful when dealing with uncertainty, while at the same time ensuring that the financial statements are neutral – that profits and losses are neither exaggerated nor underestimated – and this is known as prudence.
The Accruals Concept
The accruals concept says that net profit is the difference between revenues and the expenses incurred in generating those revenues, i.e.
Net Profit = Revenues − Expenses
Determining the expenses used up to obtain the revenues is referred to as matching expenses against revenues. The key to the application of the concept is that all income and charges relating to the financial period to which the financial statements relate should be taken into account without regard to the date of receipt or payment.
This is one of important accounting concepts which states that in determining the total amount of each asset or liability, the amount of each individual asset or liability it should be determined separately from all other assets and liabilities. For example, if you have three vehicles, the amount for which the vehicle is shown in the balance sheet should be the sum of the values calculated individually for each of the three vehicles. Only when individual values obtained must calculate a total.
Substance Over Form
Substance over form concept states that substance of the transaction should be taken into account first as compared to its legal form. Therefore, it should be reflected in balance sheet according to the substance of the transaction. Let’s take an example, you have bought a car on hire purchase.
From legal point of view, you are not the owner of the car until all the hire purchase installments have been paid and you take the option to keep the car.
From an economic point of view, you have used the car for most of it’s economic life, just like you used other cars you owned on cash basis. In this case, the car must be shown as being bought and belongs to you ( or business).
Therefore, the substance of the transaction has taken precedence over the legal form of the transaction.