What Are Accounting Concepts?
Before we talk about Accounting Concepts, it’s important to get a good accounting definition. Accounting is the process of keeping financial accounts and recording financial transactions. It also involves preparing financial statements and analyzing those financial statements. When done properly, accounting allows internal and external users to understand a company’s financial position. And this is important because we all want to do business with companies that are financially stable and likely to remain in business.
Accounting Concepts are the foundation for understanding financial accounting and cost accounting. They tell us why we record transactions and how to record the transactions. They aren’t necessarily specific rules and they may rely on the accountant’s judgement. Accounting Concepts are referred to as Generally Accepted Accounting Principles or GAAP for short. GAAP principles are a standardized method for recording transactions. Without these basic accounting principles, each company would record transactions as they see fit. This would make it nearly impossible to compare one company to another company. This, in turn, means it would be difficult to determine a company’s financial health.
How Many Accounting Concepts Are There?
There is no set number of accounting concepts. In fact, the number of concepts can change depending on circumstances. One of the first things I look for in my tutor students is a basic understanding of these concepts. I do this because the sooner they have a basic understanding of these concepts the better off they'll be. Unfortunately, different books and different professors use different terminology; as if accounting wasn't confusing enough! 🙂 The Financial Accounting Standards Board, or FASB for short, is primarily responsible for setting the standards in the United States. If new developments arise in the accounting or financial field, FASB can create new accounting concepts or accounting principles. The goal is to create appropriate guidelines to establish consistency and accuracy from one company to another. For our purpose, we'll focus on the most common concepts that students need to learn.
Basic Accounting Concepts You Need to Know to Pass Accounting Class
Accrual accounting is used to record income when it’s earned and to record expenses when they are incurred. It is closely related to the matching concept. The term Accruals refers to non-cash transactions. Usually it’s something that is owed to you, a receivable, or something that you owe, a payable.
Two common examples are Accounts Receivable and Accounts Payable. The Accounts Receivable account represents amounts that customers owe you. It’s an asset account. The Accounts Payable account represents amounts that you owe creditors. It’s a liability account. By using accruals, you can properly state the financial statements for each accounting period.
Consistency means using the same accounting principles from accounting period to accounting period. It’s possible to change principles from accounting period to accounting period, but there needs to be a good reason for the change. For example, you could change depreciation methods, but you shouldn’t change depreciation methods for the sole purpose of increasing or decreasing your net income.
Going concern implies or assumes that the business entity will continue to be in business for the foreseeable future. A business is thought to be a going concern if there is no reason to believe it will not continue. One area where this comes into play is with valuation of assets. For example, when a business is thought to be a going concern, original cost and depreciation are recorded for fixed assets. If the business is not a going concern, market price of the fixed assets should be recorded.
Prudence ( Conservation )
Remember above where I mentioned that some of the concepts have different names? Well, here’s a basic accounting concept with at least three names! I’ve always used the term conservatism, but some of my students are taught the term prudence, while others are taught the term conservation. The main idea here is that an accountant would rather error on the side of being cautious or “playing it safe.” If there is uncertainty about the numbers, they would rather overstate expenses and liabilities and understate revenues and assets. The idea is that this won’t produce misleading financial statements that present a more favorable picture of the company. Instead, they produce financial statements that are conservative.
A good example of conservatism is found in the principle of lower of cost or market value as it relates to inventory. The value of inventory can fluctuate for a variety of reasons. Due to the potential fluctuation, inventory should be valued at the lower of cost or market value. If the cost exceeds the market value, use the market value. If the market value exceeds the cost, use the actual cost.
For example, if your t-shirt company purchases 1,000 t-shirts for resale totaling $2,500, you would record an increase to inventory for $2,500. Let’s assume each t-shirt is $2.50 ($2,500 ÷ 1,000 t-shirts). If at the end of the year you had 300 remaining t-shirts, inventory would be stated at $750 ($2.50 per t-shirt X 300 t-shirts). If the market value per t-shirt is only $2.00, you would adjust your inventory value to $600 ($2.00 per t-shirt X 300 t-shirts).
Accounting Equation ( Dual Aspect )
The accounting equation is sometimes called the basic accounting formula or the basic accounting equation. The equation is: Assets = Liabilities + Equity. Depending on the type of company, Equity may be referred to as Owner’s Equity, Member’s Equity, Stockholder Equity, or Shareholder Equity. Despite the various names, the concept of equity is the same. The accounting equation encompasses the information you’ll see on a Balance Sheet. Since, it’s an equation, your Assets must always equal your Liabilities plus your Equity. If Assets don’t equal Liabilities plus Equity, you’ve calculated something incorrectly. Dual Aspect refers to the idea that for every transaction there are two sides; something received and something given up. Additionally, dual aspect means that every transaction has at least one debit and at least one credit.
For example, if you paid $1,200 for this month’s office space rent, you’d debit Rent Expense and credit Cash. You gave up $1,200 cash (Asset) and received the ability to use office for this month (Expense). For the accounting equation, your Assets decreased by $1,200 and your Equity also decreased by $1,200. This means your accounting equation is still in balance.
An accounting period refers to a calendar year (January 1 to December 31) or a fiscal year (the first day of any month to the last day of the twelfth month). For example, a fiscal year may be April 1 to March 31 or it could be July 1 to June 30. Typically a company selects their accounting period, either calendar year of fiscal year, and uses that accounting period when creating annual financial statements.
The cost basis accounting concept states that the value of a fixed asset should be recorded at the asset’s actual cost and not the asset’s current market value. The fixed asset is then depreciated over the useful life of the asset. The asset’s cost less the accumulated depreciation for that asset is referred to as the asset’s book value. For example, if you paid $4,000 for equipment, you’d record the cost of the fixed asset as $4,000. After the second year, if the accumulated depreciation was $1,600, the book value of the equipment would be $2,400. That’s calculated by subtracting the accumulated depreciation of $1,600 from the cost of $4,000.
Entity ( Economic Entity )
Another name for this basic accounting concept is the business entity concept. When a company exists, it needs to be treated separately from the owners and the owners' financials. That means the company must keep its own financial records and that financial transactions for the owners shouldn’t be recorded in the company records. If business transactions and private transactions are recorded in the company records, the company financials are inaccurate.
For example, if Jim Smith, owner of Smith Co., purchases personal groceries, the grocery purchase shouldn’t be recorded in Smith Co.’s books.
All relevant data should be disclosed in the financial statements. Full disclosure is the idea that if certain data would make a difference to an end user, it should be disclosed. Relevant information needs to be disclosed, even if it’s detrimental to the company. As transactions (or potential transactions) become more complicated, it’s important to disclose information that helps an end-user to understand the company’s financial situation.
For example, if a company is expected to lose a lawsuit, it should be disclosed, as this information would assist an end user in understanding the company's financial position.
Matching is an accounting concept that works hand-in-hand with accrual accounting. It’s often referred to as the expense recognition principle. Matching means that you recognize an expense in the same period that you generate revenue associated with that expense. This means a business will “match” the revenue earned with the expense incurred during the same time period.
For example, when a company performs and completes services on January 31st, the company records a sale during the month of January. Failure to record the expenses associated with the sale inaccurately inflates the company’s Net Income for January. Revenue - Expenses = Net Income. Expenses associated with the revenue earned must be recorded in January to properly state January’s Net Income.
Materiality works closely with the Full Disclosure concept. Basically, materiality means that Accountants should record all important transactions in the accounting records. What’s important, or material, to one company may be considered immaterial to another company. It is somewhat subjective, but the main idea of materiality is to record items that would make a difference to an end user when they are making a decision.
For example, a $10 transaction may be material to a company with annual revenue of $50,000, but the $10 transaction may not be material to a company with annual revenue of $5,000,000.
The money measurement accounting concept states that you should only record transactions that can be measured monetarily. So, if the transaction can’t be measured in money, it shouldn’t be recorded in the company’s accounting records. This makes sense because if there’s no way to allocate a dollar amount to a transaction, how could you record the transaction in dollars?
For example, a company may have competition. Their competition may have a financial impact on the company’s success, but there’s no way to measure or allocate a dollar amount to the impact of their competition.
Anyone that prepares financial statements should be free from bias. This is known as objectivity. To be free from bias, an accountant relies on supporting information. The supporting information helps a similar person (accountant) come to the same conclusion.
For example, if any accountant saw bank records indicating a purchase of inventory, shipping and receiving records related to the inventory, and physically saw the inventory, the accountant would conclude, based on supporting information, that inventory was purchased. As a result, the purchase of the inventory should be recorded in the company’s accounting records.
Also known as the revenue recognition concept, the realization concept focuses on defining when revenue should be recognized. Revenue should be recorded when it’s earned, so receiving cash may or may not determine when you recognize revenue. For example, if you perform services for a customer, you should record the revenue in your accounting records regardless of whether or not you’ve been paid. Until the customer pays, the revenue would be recorded as a debit under Accounts Receivable and a credit under Revenue or Sales. Once the customer actually pays, the payment is recorded as a debit to Cash and credit to Accounts Receivable.
Common Unit of Measure
This basic accounting concept is used to make sure financial statements are easier to understand. Under the common unit of measure concept, all transactions are recorded using the same currency. If transactions happened using a different currency, the amount will be converted to the proper currency for financial reporting purposes.
For example, if a company is based out of the United States, it makes sense that the financial statements are stated in the U.S. dollar. If that company receives payment from a Japanese customer, the U.S. company would convert the Japanese Yen to the U.S. dollar.
How to Remember Accounting Concepts
Understanding examples for the basic accounting concepts will help you remember the concepts. Sometimes, especially with accounting, a term or name of the concept may not mean anything to you. So, having an example helps solidify the concept. Once you see and understand the example, the name of the concept should be easier to remember. Additionally, constant exposure to the concepts will only solidify your learnings.
If you're struggling with learning these concepts or need any other help with your accounting class, you can always reach out to me. I'm available for one-on-one tutoring here or check out some of my free videos on YouTube here.