Four important accounting concepts underpin the preparation of any set of accounts:
- Going Concern: Accountants assume, unless there is evidence to the contrary, that a company is not going broke. This has important implications for the valuation of assets and liabilities.
- Consistency: Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meaningful comparisons of financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change.
- Prudence: Profits are not recognised until a sale has been completed. In addition, a cautious view is taken for future problems and costs of the business (the are “provided for” in the accounts” as soon as their is a reasonable chance that such costs will be incurred in the future.
- Matching (or “Accruals”): Income should be properly “matched” with the expenses of a given accounting period.
The most commonly encountered convention is the “historical cost convention”. This requires transactions to be recorded at the price ruling at the time, and for assets to be valued at their original cost.
Under the “historical cost convention”, therefore, no account is taken of changing prices in the economy.
The other conventions you will encounter in a set of accounts can be summarised as follows:
- Monetary measurement: Accountants do not account for items unless they can be quantified in monetary terms. Items that are not accounted for (unless someone is prepared to pay something for them) include things like workforce skill, morale, market leadership, brand recognition, quality of management etc. This accounting concept states that only financial transactions will find a place in accounting. So only those business activities that can be expressed in monetary terms will be recorded in accounting. Any other transaction, no matter how significant, will not find a place in the financial accounts.
- Separate Entity: This convention seeks to ensure that private transactions and matters relating to the owners of a business are segregated from transactions that relate to the business. This accounting concept separates the business from its owner. As far as accounting is concerned the owner and the business are two separate entities. This will help the accountant identify the business transactions from the personal ones. All forms of business organizations (proprietorship, partnership, company, AOP, etc) must follow this assumption.
- Realization: With this convention, accounts recognise transactions (and any profits arising from them) at the point of sale or transfer of legal ownership rather than just when cash actually changes hands. For example, a company that makes a sale to a customer can recognise that sale when the transaction is legal at the point of contract. The actual payment due from the customer may not arise until several weeks (or months) later if the customer has been granted some credit terms.
- Materiality: An important convention. As we can see from the application of accounting standards and accounting policies, the preparation of accounts involves a high degree of judgement. Where decisions are required about the appropriateness of a particular accounting judgement, the “materiality” convention suggests that this should only be an issue if the judgement is “significant” or “material” to a user of the accounts. The concept of “materiality” is an important issue for auditors of financial accounts.
- Cost Concept: This accounting concept states that all assets of the firm are entered into the books of account at their purchase price (cost of acquisition + transport + installation etc). In the subsequent years to, the price remains the same (minus depreciation charged). The market price of the asset is not taken into consideration.