Accountancy is based on some very basic Accounting Concepts and they are the underlying logic of the profession. Accounting is as old as money itself but modern day accounting has its roots in the Renaissance. Luca Pacioli – a mathematician, monk and friend of Leonardo Da Vinci – is said to have developed accounting and the double-entry system that he described in his book “Summa de arithmetica, geometria. Proportioni et proportionalita” is still in use today.
The Entity Concept
The “entity concept” means treating your business as a separate entity, distinct from you as a person. This accounting concept applies whether the business is a limited company (which is then, in law, a separate entity) or a sole proprietorship or partnership (which isn’t legally a separate entity).
Therefore, if a sole trader pays money to the business bank account, the money becomes a business asset, although legally it remains a personal asset.
If you have a business selling widgets, and you give two away as presents, the correct accounting treatment is to regard you as having purchased the widgets from the business. The subsequent gift (from you to your friends) is a private transaction and is not recorded anywhere in the books of the business.
The reason behind this is so that the business’s financial position is not hidden behind the personal transactions. Treating your business as a separate entity is a good habit to get into. For instance, banks and other lenders don’t want to have to wade through all your weekly shopping bills in order to see if your business is making a profit. If you ever have a tax inspection, you don’t want the taxman going through all your personal transactions.
The Money Measurement Concept
Accounts only deal with items which have a monetary value. This is the money measurement concept.
For example, an asset such as a machine can be valued at its original purchase cost, its replacement cost (asset valuation and accounting can take up a whole accountant) but the flair and talent of a manager or employee has no easily identifiable monetary value.
That said, in the world of sport, transfer fees appear to provide an objective valuation of a player’s worth but in almost all cases, the clubs make no attempt to include the value of players on their balance sheet. Usually, transfer fees are shown as a cost in the profit and loss account.
It is partly because of the Money Measurement Concept, that there are often issues around accounting for brand names. Brand valuation as it can be a very subjective exercise, indeed there are consultancies that just work on brand valuation as their specialisation. For instance, how much more would you be willing to pay for a big name brand instead of a bog-standard generic product? It would probably depend on several factors, many of the social or psychological as well as economic. For this reason, it’s very difficult for companies to arrive at a monetary value on a brand name. The value of brands can rise and fall with changes in consumer tastes but many companies’ balance sheets feature brand values as assets.
The Prudence Concept
Accountants are a cautious lot. If there are alternative accounting procedures or valuations then the most pessimistic one is normally chosen. This is the prudence concept: that is, giving the most cautious picture of the financial position.
For example, it is quite common to have unsold goods at the end of a financial year, in the balance sheet. With the prudence concept, they will be valued at their purchase cost (say, £100 each) rather than their sale price of £150. If you valued them at their sale price of £150, then you would have anticipated making a profit of £50 before you had actually sold them.
If a loss is anticipated then it should be taken into account immediately. So, for example, say a business purchases stock for £1,200. If there is a sudden slump in the market, it can only be sold for £900, then the stock should be valued at £900 in the accounts. This recognises the £300 loss immediately.
The prudence concept means not counting your chickens before they’re hatched.
If later, you discover that you have previously been too cautious, then you can adjust your accounts.
The Accruals Concept (The Matching Concept)
The accruals concept is often called the matching concept. When, calculating profits it is income minus the expenditure incurred (in earning that income)
Income and expenditure must be matched in each financial year (or month, if monthly accounts are done)
This ensures that the profits are fairly calculated.
For example, lets say a business bought 20 buckets but only sold 18 of them. It would be wrong to charge the profit and loss account with the cost of all 20 buckets, as there are still 2 in stock. So, the profit would be calculated based on expenditure on 18 buckets. If you were to ignore this concept, then your reported profit would be lower that it really was.
The Going Concern Concept
This concept assumes that the business is a going concern. This assumes that it will continue to operate for the foreseeable future and that it isn’t suddenly going to cease trading. The significance of this concept is that the business assets are not valued at their “break-up” value. The break-up value is the amount that they would sell for if they were sold off piecemeal.
Suppose Jo Bloggs acquired a widget making machine at £100,000 and this machine has an estimated life of 5 years. Let us also assume that the machine has no other use outside Jo Bloggs’ business and could only be sold for scrap at £15,000 after one year. It is normal to write-off the cost of this asset to the profit and loss account, over this timeframe. That is, depreciation of £20,000 per annum would be charged to the profit and loss account. So, at the end of the first year, the value of the machine in the books, would be £80,000, rather than the £15,000 scrap value.
Although it doesn’t seem very prudent, because Jo Bloggs will continue to trade and the machine will therefore be used in the business. It is the “Going Concern” concept that allows the higher valuation.
The Materiality Concept
Accounts preparation is not an exact science. Sometimes excessive detail is not needed, as long as it does not affect anyone’s understanding of the accounts.
Unfortunately, determining whether or not an item is material is a very subject exercise. There is no absolute measure of materiality. Generally, an amount less than 5% of net profit is not considered material.
Materiality issues often arise when revaluating assets.
There are exceptions to the materiality concept. Some items are very sensitive and must always be exact. For example, directors remuneration of a limited company. Even a very small mis-statement of these items would be regarded as a material error.
The Consistency Concept
Accounting is sometimes open to interpretation. There are certain concepts and principles that are considered basic. There are also plenty of procedures that are recognized as good practice. However within these limits, there are often various acceptable methods of accounting for similar items. This is why consistency concept is important.
The consistency concept just means that you treat similar items in a similar way. You also must apply the same treatment from one period to another. This ensures that similar items or different years are still comparable.
For example, businesses can choose what the average life of an asset is. You would expect all similar items to have the same useful life. In the same way, you wouldn’t change depreciation methods every year.
If you have been consistent with your accounting, when people look at your accounts, they can confidently compare previous months or year’s results.