Accounting Principles and Concepts

Introduction

Accounting principles are the foundation of financial reporting. They provide standardised guidelines for recording and presenting financial information. These principles ensure consistency across all organisations. They help stakeholders make informed decisions.

Why are they important?

• Create uniformity in financial reporting
• Build trust among investors and creditors
• Enable comparison between different companies
• Maintain transparency in business operations

Generally Accepted Accounting Principles (GAAP)

GAAP is a comprehensive framework of accounting standards. Companies must follow these rules when preparing financial statements.

Key points about GAAP:

• Established by the Financial Accounting Standards Board (FASB) in the US
• International companies often use IFRS instead
• Ensures reliability and comparability of financial data
• Protects the interests of all stakeholders

Fundamental Accounting Concepts

1. Business Entity Concept

Core Principle: The business is separate from its owner.

What this means:

• Business transactions must be kept separate from personal transactions
• The owner’s personal assets are not business assets
• Personal expenses cannot be treated as business expenses

Real-world example:

John invests $100,000 to start a restaurant.

• This is recorded as capital in business books
• It’s not shown as John’s personal asset
• If John takes $5,000 for personal use, it’s recorded as drawings
• It cannot be shown as a business expense

Common mistakes:

• Using business cash for personal shopping
• Mixing personal and business bank accounts
• Recording family expenses as business costs

2. Going Concern Concept

Core Principle: The business will continue operating indefinitely.

What this means:

• Financial statements assume ongoing operations
• Assets are valued for continued use, not immediate sale
• Long-term planning is reflected in accounting

Impact on financial statements:

• Assets shown at cost, not liquidation value
• Depreciation spread over useful life
• Long-term liabilities are acceptable

Example:

• Machinery costs $50,000
• Useful life: 10 years
• Depreciated over 10 years, not valued at resale price

3. Money Measurement Concept

Core Principle: Only monetary transactions are recorded.

What can be recorded:

• Cash purchases and sales
• Asset acquisitions
• Expense payments
• Revenue earned

What cannot be recorded:

• Employee skills and morale
• Customer loyalty
• Brand reputation
• Management quality

Real-world application:

A company has excellent staff and strong customer relationships.

• These are valuable assets
• But they cannot be measured in money
• Therefore, they don’t appear on the balance sheet

4. Accounting Period Concept

Core Principle: Financial performance is measured over specific time periods.

Common accounting periods:

• Monthly (for internal reports)
• Quarterly (3 months)
• Annually (fiscal year)

Accounting Timeline

Standard calendar year accounting timeline used in countries like the United States, the United Kingdom, Canada, Australia, and many other nations where the fiscal year aligns with the calendar year.

Why it matters:

• Enables regular performance evaluation
• Allows comparison across periods
• Helps in planning and budgeting
• Required for tax purposes

5. Cost Concept

Core Principle: Assets are recorded at their original purchase price.

Key features:

• Also called the Historical Cost Concept
• Provides objectivity and verifiability
• Market value changes are ignored
• Easy to prove with original invoices

Example:

The land stays at $200,000 in books regardless of market value.

6. Matching Concept

Core Principle: Match expenses with the revenues they generate.

How it works:

• Record expenses in the same period as related revenue
• Ensures accurate profit calculation
• Provides a true picture of performance

Real-world example:

A retailer sells goods in December 2024:

• Sale amount: $50,000
• Customer pays in January 2025
• Cost of goods: $30,000

Correct recording:

• Revenue: Recorded in December 2024
• Expense: Recorded in December 2024
• Both matched in the same period

Common scenarios:

7. Realization Concept

Core Principle: Recognise revenue when earned, not when cash is received.

Revenue is recognised when:

• Goods are delivered or services performed
• Amount is reasonably certain
• Collection is probable

Three scenarios:

Scenario 1: Cash Sale

• Goods delivered: March 1
• Cash received: March 1
• Revenue recorded: March 1

Scenario 2: Credit Sale

• Goods delivered: March 1
• Cash received: April 15
• Revenue recorded: March 1

Scenario 3: Advance Payment

• Cash received: March 1
• Goods delivered: April 15
• Revenue recorded: April 15

Common mistake: Recording revenue when an advance is received, not when goods are delivered.

8. Dual Aspect Concept

Core Principle: Every transaction has two effects.

The Accounting Equation:

ASSETS = LIABILITIES + OWNER’S EQUITY

This equation must always balance.

Example: Purchase equipment for $10,000 cash

Before Transaction:

Assets = $50,000

Liabilities = $20,000

Equity = $30,000

Transaction Effect:

Equipment (Asset) +$10,000

Cash (Asset) -$10,000

After Transaction:

Assets = $50,000 (no change)

Liabilities = $20,000 (no change)

Equity = $30,000 (no change)

Another example: Borrow $20,000 from the bank

Both sides of the equation increase equally.

How Principles Guide Daily Accounting

When recording any transaction, ask these questions:

Checklist for Recording Transactions:

1. Business Entity: Does this belong to the business?
2. Money Measurement: Can it be expressed in monetary terms?
3. Accounting Period: Which period does it belong to?
4. Cost Concept: What was the original cost?
5. Matching: Does it relate to any revenue?
6. Realisation: Has revenue actually been earned?
7. Dual Aspect: What are the two effects of this transaction?
8. Going Concern: Is this for ongoing operations?

Common Mistakes to Avoid

Business Entity Violations:

• Paying personal rent from a business account
• Using the company car for a family vacation
• Recording spouse’s salary when they don’t work

Matching Concept Errors:

• Recording December sales in January
• Expensing the entire insurance premium at once
• Not matching the cost of goods with sales

Realisation Concept Mistakes:

• Recording revenue when the order is received
• Recognising income from advance payments
• Booking sales before goods are shipped

Cost Concept Errors:

• Revaluing assets based on market prices
• Recording assets at estimated values
• Adjusting land value due to appreciation

Dual Aspect Failures:

• Recording only one side of the transaction
• Unbalanced journal entries
• Missing corresponding debit or credit

Impact on Financial Statements

Balance Sheet:

• Shows assets at historical cost
• Reflects business entity only
• Assumes going concern
• Must balance (dual aspect)

Income Statement:

• Covers a specific accounting period
• Matches revenues with expenses
• Recognises revenue when earned
• Shows only monetary items

Cash Flow Statement:

• Reports actual cash movements
• Organised by accounting period
• Separates business from personal flows

Summary Table: Principles at a Glance

Conclusion

These eight principles form the backbone of accounting. They work together to create reliable financial information. Master them early in your studies. They apply to every transaction you’ll ever record.

Key points to remember:

• Principles ensure consistency
• They protect stakeholder interests
• They make financial data comparable
• They’re based on logic, not arbitrary rules

Next steps:

• Practice identifying principles in real transactions
• Review financial statements with these concepts in mind
• Apply them in your accounting exercises
• Understand how violations affect financial reporting

These concepts will become second nature with practice. They’re essential for your accounting career.