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35. Scope and Basic Concepts

Basic Accounting Concepts

Before we learn how to keep proper accounting records, summarize and interpret the recorded information, we must be clear about certain accounting concepts, i.e. established rules, principles and ideas upon which the practice of accounting is largely based.

Business Entity

Each business is a separate entity from its owner.

For accounting purposes, the business is regarded as an entity or a unit by itself.  It exists separately from its owner.  This means that all financial information relating to the business is recorded and reported separately from the owner's personal financial information.  Thus, if Peter Day owned and managed a provision store, the accounting records and reports for the store would not contain either the private expenditure or the personal property of Peter Day.  Similarly, the personal accounting records for Peter Day will not contain transactions of the store.

The only time that the personal resources of the trader affect the accounting records of the business is when he brings in personal property as new capital into the business or when he makes drawings from the business for personal expenses.

Going Concern

The business entity will continue to operate indefinitely.

In accounting, the business is always assumed to be a going concern, i.e. to operate for an indefinite period of time.  Thus, it is not in the interest of the business to know the realizable or saleable value of its assets, i.e. the value of its assets if the business were to be sold.

Historic Cost

All transactions of a business entity are recorded at the original cost to the enterprise.

It is the accounting practice to record all assets at cost price.  This means that a piece of land purchased years ago is still recorded at its original cost even though its value is considerably higher now.  This practice is based on the assumption that the business is a going concern and is not likely to be liquidated and so the market or realizable value is not relevant.

Objectivity

There must always exist objective verifiable for reporting any accounting information.

The evidence that a business transaction has taken place and the details pertaining to that transaction are contained in a source document.

Source documents are examples of objective evidence of transactions that have take place.  These documents include receipts, invoices, cheques and vouchers.

All accounting entries are supported by these source documents.

It is this desire for objectivity that also explains why historical cost rather than current market value forms the basis of valuation of assets.

The cost price of the purchase of an asset can be objectively verified through the documentary evidence of its purchase either in the form of an invoice (in the case of a credit purchase) or a receipt (in the case of a cash purchase).

Consistency

In the preparation of financial reports, the same accounting method should be applied in each accounting period.

It is important that once a particular accounting method is adopted, it must not be changed from period to period.

Consistency in accounting methods is observed to avoid misleading profits arising from differing accounting methods from being reported.

Moreover, a comparison of the results of one period with the next can be made if the same accounting method has been used in both periods.

Conservatism

Conservatism or prudence is observed when reporting all accounting information.

Cautious accounting practices are observed so that assets are neither overrated nor liabilities underrated.  All losses, suffered or anticipated, are recorded and accounted for while profits should be understated rather than overstated.

This explains why closing stock is always valued at the lower of cost or market value so that profits are not overrated during the current period.

Accounting Period

The life of a business is divided into specified periods of time for the purpose of preparing financial reports.

With the assumption that the business is a going concern, it is not possible to wait until the end of the life of the entity to measure its performance.  Thus, the life of a business entity is divided into specified periods of time for the purpose of preparing financial reports.  Such a period is called an accounting period.  The period may be a month, a half-year, a full year or any length of time, depending on the volume and nature of the business.

Accrual Concept

Revenue is recognized when it is earned and expenses when they are incurred.

Revenue is recognized and recorded as earned as soon as goods are sold or services performed, even though payment has not yet been received.

Similarly, expenses are considered as incurred even though payment for the expense has not been made.

Expenses that are owing are termed as accrued expenses and are added to expenses that have been paid to give the total expenses for the period under consideration.

Accrual accounting is to be contrasted with cash accounting which recognizes revenue and expenses only when cash is received or paid out.

Matching Principle

Revenue earned during an accounting period has to be matched with the expenses associated with earning that revenue.

The matching principle is based on the accrual concept of accounting.  To comply with the accounting period and accrual concepts, it is necessary to make various adjustments to the normal accounting process.

Revenue earned during a specific period has to be matched with appropriate expenses incurred in earning that revenue so as to arrive at the true profit for the specific period.

This means that accrued revenue and expenses are included in the matching process while revenue received and not yet earned and expenses paid and not yet incurred should be left out in the matching process.

Summary