Reports and other accounting information are produced so management, investors, creditors, government, or other stakeholders can take actions based on this accounting information. If you consider every organization type, every organization location, how can we all speak the same language and make the best decisions?
The answer to this is that accountants follow a basic set of concepts and principles whenever they practice accounting. This allows us to achieve reliability, relevance, and comparability in the information produced by financial accountants.
Fundamental Accounting Equation
The fundamental accounting equation expresses the relationship of the organization’s assets with its own capital and liabilities and has the following form:
Assets = Liabilities or
Assets = Equity + Liabilities
This equation can be interpreted in two ways. On the one hand, the equation shows how the organization’s assets are financed at any specific time: either by owners (equity) or creditors (liabilities). On the other hand, the equation shows the claims of different persons in relation to the assets of the organization, i.e. claims of owners (equity) and claims of creditors (liabilities).
In the event of liquidation of the organization, owners and creditors have the right to claim the assets of the organization. Claims are satisfied as follows:
- Creditors have a priority claim on the assets of the organization. If the debt claims of creditors are not met, then they have the right to collect the debt through the court.
- The owners have the right to claim the remaining assets of the organization. The owners of the organization own only what remains after settlements with creditors, i.e. after all obligations have been paid.
Concepts and Principles
Let’s go over the definition and explanation of fundamental concepts and principles that bookkeepers and accountants follow.
Entity concept
When we perform the act of accounting and present accounting information, we are presenting accounting information and measuring accounting data about a particular entity and that entity alone. The entity can be an organization or a section of an organization, like a department or a division.
The data on a particular entity should not be mixed up with other uncontrollable or irrelevant entities. For example, you will not mix the information for the marketing department with some data for the productions department or you keep your personal financial activities separate from your business activities.
Accounting period concept
An accounting period is simply a unit of measurement. The idea behind this concept is that the life of an organization is indefinite, so to get value out of our accounting reports, we have to have some sort of set time period to make a comparison between one report and another report and one period to another. Often, these are regulatory required accounting periods.
Cost principle
This principle is based on the idea that accounting value is based on transaction costs. In other words, we do not record transactions on what we “think” they are worth. Instead, we base all values on financial transaction evidence. For a historical cost, we might use invoices or receipts to prove the value of our transactions and the value of our assets and expenses. For fair value, valid documentation is used.
Matching principle
This is one of the important principles to know. According to its definition, we have to match expenses against the income they generate. You can think of expenses as inputs into the business, so we spend money on things that go into the business and then generate income from selling the outputs. Lining up these inputs and outputs against each other allows getting an accurate measure of profit (income less expenses).
Profit recognition principle
According to this principle, we should only recognize profit/revenue when it is earned and can be reliably measured. In other words, revenue recognition is not associated with cash being received, but the actual sale of goods or provision of services.
Conservatism principle
The idea behind this principle is that we should anticipate no profit and anticipate all losses. It is an attempt to remove optimism from working its way into financial data. If everyone in the business is too optimistic, it is too easy for optimistic valuations, income recognition, and other inaccurate data to get into the financial data and reports. So, we should be 100% certain that we earned the profit before recording it, but if any expenses are anticipated, we would recognize them early.
