Fundamental Accounting Concepts
Fundamental accounting concepts are enforced through accounting standards and/or company law.
- Going concern concept: This concept states that we must assume that a business will continue to operate for the forseeable future and it follows that we should use historical cost when valuing assets. In exceptional circumstances, however, we are able to reject this concept. For example, such curcumstances might include knowledge that a company is short of cash and is likely to cease trading shortly. In this circumstance we would prefer to value assets at their expected sale price.
- Consistency concept: Once a businesses has decided upon a method for the accounting treatment of an item, it will enter all similar items that follow in the same way. A business may decided to change its method for the accounting treatment of items, but this should not be done without a great deal of thought. If the change in method has a material effect on the values disclosed in the financial statements then the effects of the change should be stated.
- Prudence concept: Caution will be exercised when dealing with uncertainty, but not to the extent that financial statements cease to be neutral (i.e. don’t be more cautious than we need to be).
- Realisation concept: Rather than being a separate concept, this is usually considered to be subsidiary to the prudence concept. The realisation concept states that profits should only be taken into account when “realisation” occurs. Realisation occurs only when the ultimate realised cash is capable of being determined with reasonable accuracy (i.e. goods/services provided, buyer accepts liability to pay, monetary value is agreed, and the buyer is known to be in a position to pay). This is not the same time that the order is received or the time that the customer actually pays.
- Accruals concept: The accruals concept states that net profit is the difference between the revenues earned and the expenses incurred in generating those revenues (i.e. Revenues - Expenses = Net Profit). Determining the expenses used to generate revenues is known as “matching” expenses against revenues. Key to the appreciation of this concept is that all income and charges relating to the financial period to which the financial statements relate should be taken into account, regardless of the date of receipt or payment.
- Separate determination concept: This concept states that when determining the aggregate amount of each asset or liability, the amount of each individual asset or liability should be determined separately from all the rest. For example, a business with 3 machines would record in the balance sheet the sum of the individual values of the 3 machines.
- Substance over form concept: This concept states that if the legal form of a transaction differs from its real subsance then the accounting treatment should be in accordance with the real substance of the transaction. For example, a business undertaking the hire-purchase of a vehicle will not own the vehicle until all installments are paid and the option to take legal possession is exercised. However, from an economic point of view the vehicle will be used just as if it had been purchased outright. The correct accounting treatment would be to show the vehicle being bought via hire-purchase on the balance sheet as if it were legally owned by the business, but also to show separately the amount owed for it.