Accounting Concepts

The accounts are prepared on the basis that the business is expected to continue trading in its present form for the forseeable future (at least the next 12 months).  Therefore if a business is considered to be a going concern, all assets are valued at historic (original) cost; if the business is not a going concern, break-up values are used instead, that is, the value the assets are expected to fetch when sold off. Reasons why a business might cease to be regarded as a going concern include loss of major customers or suppliers such that the business is no longer viable, significant damage to reputation of business or its products, decision to retire by a sole trader etc.

Sales should be recorded in the Trading, Profit and Loss Account in the accounting period in which they are earned (i.e the goods have been sent to the customer), even though the money may not have been received in that period.  Costs should be recorded in the accounting period in which they are incurred (i.e. purchased goods have been received or a service has been provided resulting in an expense for the business), even though they may not have been paid for in that period.  eg if a business makes up its accounts to the 31st December 2013, then a sale of goods invoiced and despatched on 20th December 2013 will be recorded in 2013's profits, even if the customer does not pay for the goods until some time in January 2014. The accruals concept is the reason why we have debtor and creditor values in the accounts.

This concept also requires that costs should be matched in the same accounting period as far as possible against the sales revenue they help to earn.  This matching principle requires the depreciation of fixed assets and the use of Cost of Goods Sold (rather than simply Purchases) in the TPL.

Accountants should take a cautious approach to the valuation of assets and the calculation of profit.  It is better to understate rather than overstate these amounts. A loss in value should be recorded in the Trading, Profit and Loss Account as soon as it is anticipated even if the reduction in value has to be estimated and is not yet known exactly (eg doubtful debts, write-off of damaged stock)

An extension of the cautious approach.  Profits should not be anticipated. Therefore sales revenue should not be recognised in the Trading, Profit & Loss Account until exchange of goods or services has taken place

The accounts should be prepared on the same basis every year i.e similar items should be treated the same way as each other both within each accounting period and from one period to the next.  For example, if a business has several vehicles that it owns, it should use the same method of depreciation for all the vehicles and not change the method in different years.  The reason for this is to prevent accountants trying to manipulate profit figures to make them appear better.

Accounts should be prepared using the original costs incurred in a transaction because this can be verified by evidence such as an invoice.  This makes the value used more objective.  The problem with choosing other ways of valuing transactions is that they tend to be more subjective and therefore more open to manipulation of the accounts to make the business performance look better.  However, one problem with historical cost is that accounts do not show the impact of inflation on long term asset values.

The financial affairs of the business should be recorded separately from the owner's financial affairs.  The only link between them is the recording of the capital owed to the owner and the reduction of that capital via drawings. Personal expenses cannot be treated as business expenses - if the business pays for a personal expense, it must be shown as drawings and not in expenses.

The way in which accounts are prepared may depend upon the significance of the transaction being recorded or the adjustment being made.  For example, although a door mat costing £5 may have long term use in the business, it would not be treated as a fixed asset and depreciated over several years.  Instead it will be treated as an expense in the TPL in the year of purchase.

So a normal treatment of an item in the accounts may not apply if it makes no significant difference to profit values or asset values whatever treatment is used.

The value of transactions, assets, liabilities or capital should only be recorded where they can be measured in monetary terms at a value that can be objectively reached (i.e most people would agree with it because, for example, there is an invoice showing the value of a transaction). 

An example of an asset that cannot be measured objectively in monetary terms is the value of a strong management team.  It may well "add value" to the business, but who can say conclusively exactly how much that extra value should be recorded at in a Balance Sheet?  Therefore nothing is recorded at all.

This concept states that every transaction has two effects on a business' accounts.  It is therefore the reason why the double entry system of bookkeeping is used in preparing accounts.  It allows the preparation of the Trial Balance to check the accuracy of the double entry.  It also underpins the preparation of the Balance Sheet which shows the two aspects of a business' financial position as reflected in the accounting equation i.e the value of its net assets and how those assets have been funded.