Core Accounting Principles and Concepts (AS Level) Financial accounting

 

Core Accounting Principles and Concepts

  1. Duality
  2. Business Entity
  3. Money Measurement
  4. Historic Cost
  5. Realisation
  6. Consistency
  7. Materiality
  8. Matching (Accruals Concept)
  9. Prudence (Concept of Conservation)
  10. Going Concern
  11. Substance over Form

 Detailed Breakdown of Concepts

1. Duality

The concept of duality recognizes that every transaction has two aspects. This is represented by the corresponding debit and credit entries made in the accounts. Duality forms the basis of the accounting equation, which states: assets minus liabilities equals capital (Assets – Liabilities = Capital).

2. Business Entity

This principle regards every business as having an existence separate from that of its owner.

  • When an owner introduces capital, the capital account is credited, showing the owner as a creditor of the business.
  • When the owner withdraws money, the amount is debited to their drawings account.
  • The business accounts should only record business transactions; if an owner incorrectly charges a personal expense (like a holiday) to the business, the expenses are overstated, and the true profit is not shown.

3. Money Measurement

Only transactions that can be expressed in monetary terms are recorded in the ledger accounts. Assets, trade receivables, and expenses are included because they can be quantified monetarily.

  • Limitation: This principle excludes items that cannot be quantified monetarily, such as the skills of workers or their job satisfaction, which some believe should be included in financial statements.

4. Historic Cost

Transactions are recorded at their cost to the business. Cost is considered reliable because it can be supported by documentary evidence, such as invoices.

  • Limitation: This approach ignores the changing value of money over time (e.g., due to inflation). Using historic cost may produce misleading results if its limitations are not understood.

5. Realisation

Realisation means that revenue is recognized or accounted for by the seller when it is earned, regardless of whether cash has been received from the transaction. A sale is realized when cash or a debtor replaces goods or services.

  • This principle prevents revenue from being credited in the accounts before it has actually been earned.
  • For goods sent on "sale or return," no sale is realized until the customer informs the seller they have decided to buy the goods.

6. Consistency

Transactions of a similar nature must be recorded in the same way (consistently) in the current accounting period and in all future accounting periods.

  • Consistency is vital for ensuring that the profits or losses of different periods, and subsequent statements of financial position, can be compared meaningfully.
  • For example, once a method of depreciation is chosen for an asset, it should be used consistently.

7. Materiality

A business may occasionally depart from generally accepted principles if the amounts involved are not considered material (or significant) in relation to the overall figures in the income statement and statement of financial position.

  • What constitutes a material item is subjective and depends on the scale of the business. For a large company, a small asset purchase might be treated as revenue expenditure (expense), but for a small sole trader, the same item might be significant enough to be treated as capital expenditure (an asset) so as not to distort the profit.

8. Matching (Accruals Concept)

This concept ensures that revenue and other income are accurately related to the period covered by the financial statements, and that expenses are matched to the revenue earned. Expenses should be shown in the income statement as they have been incurred rather than as they have been paid.

  • Providing for depreciation is an application of the matching principle, distributing the cost of a non-current asset over its useful life and matching the charge against the revenue it helps generate.
  • Chapter 10 (Accruals and prepayments) focuses on the practical application of the matching principle.

9. Prudence (Conservation)

The prudence concept aims to prevent profit from being overstated. If profit is overstated, the owner might withdraw too much money, leading to the depletion of capital.

The correct procedure dictated by prudence is:

  • Profits should not be overstated (they should be realistic, not necessarily understated).
  • Losses should be provided for as soon as they are recognized.
  • Inventory valuation follows this concept by using the lower of cost and net realisable value.

10. Going Concern

Unless stated otherwise, it is assumed that the accounts of a business are prepared on the basis that the business will continue trading in the foreseeable future and that there is no intention to discontinue it.

  • If a business is not a going concern, its assets must be valued in the statement of financial position at the amounts they could be expected to fetch in an enforced sale.

11. Substance Over Form

This principle states that the economic substance of a transaction (the practical reality) must be recorded in the financial statements rather than focusing strictly on its legal form.

  • Example: A machine purchased on hire purchase remains the legal property of the seller until the final installment is paid (the form). However, because the purchaser is using the machine in the business just like other assets, the machine is treated as a non-current asset of the purchaser (the substance).

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