Text b accounting concepts

Accounting professionals are guided by accounting concepts. The twelve concepts described in this chapter are commonly accepted by all professional accountants. Throughout this textbook, materials and procedures are described which apply one or more of these concepts.

CONCEPT: Business Entity

A business' financial information is recorded and reported separately from the owner's personal financial information.

A person who owns a business may also own a personal house and car. However, an individual's business financial records should not include information about the individual's personal belongings. Financial records for a business and for its owner's personal belongings should not be mixed. For example, one checking account is used for the owner and another for the business. A business exists as an entity separate from its owner.

CONCEPT: Going Concern

Financial statements are prepared with the expectation that a business will remain in operation indefinitely.

Any business is started with every expectation that it will be successful. Owners expect to continue operating their businesses well into the future. For example, Jerry Fiord starts a business expecting to continue it until he retires. When he retires, Mr. Fiord expects to sell the business, and he expects the new owner to continue the business. All accounting records and statements are prepared, as though the business will continue even after the present owner is gone. The opposite eventually may prove true, but Mr. Fiord expects his business to continue indefinitely.

CONCEPT: Accounting Period Cycle

Changes in financial information are reported for a specific period of time in the form of financial statements.

Accounting records are summarized periodically and reported to business owners and managers. The reports or statements are prepared to cover a specific period of time. The period of time may cover a month, three months (quarter of a year), six months (half a year), or a year. Most individuals summarize personal financial information once a year in order to prepare tax reports.

CONCEPT: Objective Evidence

Each transaction is described by a business document that proves the transaction did occur.

A business transaction should be recorded only if it actually occurred. The amounts recorded must be accurate and true. Nearly all business transactions result in the preparation of a business paper. Checks are prepared for cash payments. Receipts are prepared for cash received. Sales slips are prepared for items sold. One way to check the accuracy of specific accounting information is to look at the business paper giving details of the transaction. Most accounting entries are supported by business forms.

CONCEPT: Unit of Measurement

All business transactions are recorded in a common unit of measurement— the dollar.

Accounting records are used to prepare financial reports. Reports would not be clear if some information were reported in dollars and some in Swiss francs. In the United States, a business' financial information is reported in dollars, a common unit of measurement. In Ukraine, a business’ financial information is reported in Hrivnas, our nation's common unit of measurement.

Also, a count of items owned is not a good common unit of measurement. Some items are counted as single items, such as one truck and five tractors. Other items may be counted as single items or groups of items, such as twelve eggs or one dozen eggs. A business would have difficulty in figuring its worth from a record showing only a unit count of items owned.

CONCEPT: Realisation of Revenue

Revenue from business transactions is recorded at the time goods or services are sold.

Some businesses sell goods or services for cash only. Other businesses sell goods or services on one date and receive payment from customers on a later date. Judy Calhoon buys a dress for $75.00 on September 1. She pays the store on October 1. The store records the sale on September 1, not on October 1 when the cash is received.

CONCEPT: Matching Expenses with Revenue

Revenue from business activities and expenses associated with earning that revenue are recorded in the same accounting period.

Joyce McPherson operates a public accounting firm and uses a monthly accounting period. In February she spends $150.00 for gasoline used while driving back and forth to clients' businesses. She also spends $360.00 for supplies. These amounts are expenses of her business. Ms. McPherson receives $700.00 for her services to clients. She should record the revenue, $700.00, and the expenses, $510.00, in February, the same accounting period. Ms. McPherson's February financial statements must show how much she earned and how much it cost her to earn the revenue.

CONCEPT: Historical Cost

The actual amount paid or received is the amount recorded in accounting records.

A microcomputer is advertised at a price of $1,500.00. However, John Workoski arranges to buy the microcomputer for $1,200.00. The micro­computer is recorded at a value of $1,200.00. A year later, Mr. Workoski has a disk drive installed in the microcomputer at a cost of $695.00. His total historical cost is now $1,895,00, Mr. Workoski believes he could sell the microcomputer for §2,000.00. However, accounting practice requires that all things be recorded at a historical cost that is known. Therefore, Mr. Workoski's records continue to show the microcomputer's value as $1,895.00, the definite, known value.

CONCEPT: Adequate Disclosure

Financial statements should contain all information necessary for a reader to understand a business' financial condition.

Many persons need a business' financial information. These persons include owners, managers, bankers, and other executives. All financial information must be reported if good business decisions are to be made. A financial statement with incomplete information is similar to a book with missing pages. The complete story is not told.

CONCEPT: Consistent Reporting

In the preparation of financial statements, the same accounting concepts are applied in the same way in each accounting period.

Sarah keeps records about her school costs. In her personal records last year, Sarah reported the number of lunches she bought at school. This year Sarah reported the amount she spent for lunches at school. Sarah cannot compare her lunch costs for the two years very effectively because she has not been consistent in reporting lunch costs.

Owners and managers use information reported on financial statements when making business decisions. Information from one year is often compared to similar information for the previous year. If accounting information is recorded and reported differently from one year to the next, the information cannot be compared. Unless changes in recording and reporting make information more easily understood, changes in accounting methods are not made.

CONCEPT: Prudence

Revenues and profits are only included in the accounts when they are realized or their realization is reasonably certain.

This is the concept that where alternative procedures, or alternative valuations, are possible, the one selected should be the one which gives the most cautious presentation of the business’s financial position or results.

CONCEPT: Materiality

Some types of expenditure are less important in a business context than others. So, absolute precision in the recording of these transactions is not absolute essential.

Determining whether or not an item is material is a very subjective exercise. There is no absolute measure of materiality. It is common to apply a convenient rule of thumb (for example to define the material items as those with a value greater than 5% of the net profit disclosed by the accounts). But some items disclosed in accounts are regarded as particularly sensitive and even a very small misstatement of such an item would be regarded as a material error.

The assessment of an item as material or immaterial may affect its treatment in the accounts. For example, the profit and loss account of a business will show the expenses incurred by the business grouped under suitable captions (heating and lighting expenses, rent and rates expanses and so on); but in the case of very small expenses it may be appropriate to lump them together under a caption such as “sundry expenses”, because a more detailed breakdown would be inappropriate for such immaterial amounts.