PART 1: ACCOUNTING CONCEPTS

Accounting concepts: Are the rules of accounting that should be followed in

preparation of all accounting and financial statements.

MONEY MEASUREMENT CONCEPT

Money measurement concept (also known as monetary unit assumption) states that all
accounting records should be made in terms of monetary units. All transactions are
measured in monetary units and recorded in the books of accounts in terms of money
which is generally the currency unit used in the country. In Malaysia, for example, all
accounting records are maintained in terms of RM-Malaysia. A multinational
company, however, may maintain accounts in dual currencies.
This means that a business should only record an accounting
transaction if it can be expressed in terms of money. Therefore, if the items
cannot be expressed in terms of money so the items cannot be recorded as
accounting transactions. For example:
 Employee skill level.
 Employee working conditions.
 Motivation of staff,
 Hard work of management.
 loyalty of customers

ENTITY CONCEPT
The business entity concept, also known as the economic entity assumption, states
that all business entities should be accounted for separately. The owner and the
business are two separate entities and should be accounted for separately. The same
goes for partnership and corporations. The partners and shareholders’ activities should
be kept separate from the partnership and corporate transactions because they are
separate economic entities.

The business entity concept of accounting is useful for financial statement users for
several reasons:

1. They can differentiate between the actual company activity and the ownership
involvement.

1
 2. The business entity concept is essential to separately measure the performance
of a particular business in terms of profitability and cash flows etc.
3. It helps in assessing the financial position of each and every business
separately on a particular date.
4. It becomes difficult and impossible to audit the records of a business if they
are intermingled with those of different entities/individuals.
5. The concept ensures that each and every business entity is taxed separately.

EXAMPLES OF ENTITY CONCEPT

1. Mr John has acquired a floor of a building having 3 halls for $1,500 per
month. He uses two halls for his business and one for personal purpose.
According to business entity concept, only $1,000 (the rent of two halls) is a
valid expense of the business.
2. Mr Sam owns a company. He uses two different credit cards – one for the
payment of business expenses and one for the payment of personal expenses.
He pays $200 as the electricity bill of his company using his personal credit
card. According to business entity concept of accounting, the electricity bill of
the business should have been paid using company’s credit card. The payment
of $200 using personal credit card would therefore be considered as the
contribution of additional capital by Sam.
3. The owner of a business loans $100,000 to his company. This is recorded by
the company as a liability, and by the owner as a loan receivable.

GOING CONCERN CONCEPT

The going concern concept of accounting implies that the business entity will
continue its operations in the future and will not liquidate (close down or wind up) or
be forced to discontinue operations due to any reason. A company is a going concern
if no evidence is available to believe that it will or will have to cease (end) its
operations in foreseeable future.

Examples OF GOING CONCERN CONCEPT

1. A company manufactures a chemical known as Chemical-X. Suddenly, the

government imposes a restriction on the manufacture, import, export,
marketing and sale of this chemical in the country. If Chemical-X is the only
product that company manufactures, the company will no longer be a going
concern.
2. The Eastern Company closes one of its branches and will continue with others.
The company is a going concern because the shutting down a small part of

2
 business does not impair the ability of the company to operate as going
concern.
3. The Small Company is unable to make payments to its creditors due to a very
weak liquidity position. The court grants the order of liquidating the company
upon the request of one of the company’s creditors. The company is no longer
a going concern because sufficient evidence is available to believe that the
company cannot continue its operations in future.

COS CONCEPT

The cost concept (also known as cost principle of accounting) states that the assets
and liabilities of a business should be presented in accounting records at their
historical cost.

Historical cost is the amount that is originally paid to acquire the asset and may
be different from the current market value of the asset. Let us assume, for example,
that an herbal medicine company purchases a piece of land for growing herbs on it,
paying $25,000 in cash. The company will enter $25,000 as the cost of the land in its
accounting records. In a booming real estate market, the fair market value of the land
five years later might be $35,000. Although the market price of the land has
significantly increased, the amount entered in the balance sheet and other accounting
records would continue unchanged at the cost of $25,000.

A similar presentation is also required for liabilities. Companies issue various

liabilities (such as accounts payable, bills payable, notes payable, bonds payable etc.)
in exchange for goods and services. These liabilities are normally reported at their
cost. For example, a company acquires a tract of land at an agreed price of $12,000
and issues a note payable amounting to $12,000 for the full payment. The cost of note
payable to be entered in accounting records would be $12,000.

Examples of cost concept or cost principle

1. The Washington Company constructed a building at a cost of $45,000 in 2005.

On December 31, 2017, the fair market value of the building is $65,000 but
still stands on the balance sheet at its original cost of $45,000.
2. The New York Company purchased a tract of land for $50,000 on January 1,
2010. Today the fair market value of the land is $65,000. Although the
economic value or market price of the land has increased, the company would
continue reporting it at its historical cost of $50,000.
3. The Lasagne Stone Crushing Company purchased a piece of equipment for
$10,000 several years ago. Today, the worth of equipment is only $2,500 but
the company would still report it at original cost less accumulated
depreciation.

3
 4. Mexico Trading Company purchased 1,000 units of an item last quarter for $1
per unit. The current price of inventory is $1.25 per unit. The company would
report inventory at purchase price of $1,000 and not at $1,250.

DUAL ASPECT CONCEPT

The dual aspect concept states that every business transaction requires recordation in
two different accounts. This concept is the basis of double entry accounting, which is
required by accounting frameworks in order to produce reliable financial statements.
The concept is derived from the accounting equation, which states that:

Assets = Liabilities + Equity

Under this concept which is the basis of double entry accounting, aspects of
transactions are classified under two main types:

1. Debit
2. Credit

According to this concept for every debit, there is a correspondence credit and vice
versa. Every transaction has two aspects. These two aspects may be:

1. An increase in asset and decrease in other assets

2. An increase in asset and simultaneously increase in liability
3. A decrease in asset and increase in another asset
4. A decrease in asset and decrease in liability

Similarly, there may be:

5. Decreases in one liability, decrease in other liability

6. Increase in one liability increases in another asset
7. Decrease in liability increases in other liability
8. Decrease in liability and decrease in an asset

Examples of dual aspect concept

1. Payment of salary to staff $2,000

2. Sale of books for cash $5,000

4
Account Title Effect Debit Credit
$ $
1. Salary Expense Increase in expense 2,000
Cash at bank Decrease in assets 2,000
2. Cash in hand Increase in assets 5,000
Sales revenue Increase in income 5,000

ACCOUNTING PERIOD CONCEPT

An accounting period is the period of time which financial statements are
prepared. For example, the income statement and the cash flow statement report the
amounts occurring during the accounting period, and the balance sheet reports the
amounts of assets and liabilities as of the final moment of the accounting period.

The length of accounting period to be used for the preparation of financial

statements depends on the nature and requirement of each business as well as the need
of the users of financial statements. Normally, an accounting period consists of a
quarter, six months or a year. A company with a June fiscal year would start its period
on June 1 and end it on May 31 of the following year.

This concept is an essential for business organizations because it enables business

organizations to stop and see how successful they have been in achieving their
objectives during a particular period of time and where the room for improvement
exists.

CONSERVATISM PRINCIPLE
The principle of conservatism gives guidance on how to record uncertain events and
estimates. The principle of conservatism states that you should always error on the
most conservative side of any transaction. Most of the time this means minimizing
profits by recording uncertain losses or expenses and not recording uncertain or
estimated gains.

REALIZATION CONCEPT

The basic idea of realization concept is from the recognition of revenue. In

accounting, the revenue from sale of goods or provision of services is recognized at
the time they are delivered or provided to customers. Under this principle, revenue is
recognized by the seller when it is earned irrespective of or regardless of whether cash
from the transaction has been received or not.
5
Example

1. A customer pays $1,000 in advance for a customer-designed product. The seller

does not realize the $1,000 of revenue until its work on the product is complete.
Consequently, the $1,000 is initially recorded as a liability (in the unearned
revenue account), which is then shifted to revenue only after the product has
shipped.

MATCHING CONCEPT

Matching principle is one of the most fundamental principles in accounting. It

requires that a company must record expenses in the period in which the related
revenues are earned. Matching concept is at the heart of accrual basis of accounting.
Matching principle is what differentiates the accrual basis of accounting from cash
basis of accounting. It requires recognition of revenues and expenses regardless of the
actual receipt of cash from revenues and actual payment of cash for expenses. For
example, Expenses such as salaries, rent, insurance, are the basis of period to which
they relate and not when these are paid.

It is important to match expenses with revenues because net income, i.e. the net
amount earned in a period, is calculated by subtracting expenses from revenues. If
expenses are not properly recorded in the correct period, the net income for a
particular period may be either understated or overstated and so are the related
balance sheet balances.

CONSISTENCY CONCEPT
The concept of consistency means that accounting methods once adopted must be
applied consistently in future. Also same methods and techniques must be used for
similar situations.

The consistency principle does not state that businesses always have to use the same
accounting method forever. Companies are allowed to switch accounting methods if
the company can demonstrate why the new method is better than the old method. The
company then must disclose the change in its financial statement notes along with the
effect of the change, date when the change occurred, and the justification for the
accounting method change.

Examples

1. Company A has been using declining balance depreciation method for its IT
equipment. According to consistency concept it should continue to use
declining balance depreciation method in respect of its IT equipment in the

6
 following periods. If the company wants to change it to another depreciation
method, say for example the straight line method, it must provide in its
financial report, the reason(s) for the change, and the nature of the change and
the effects of the change on items such as accumulated depreciation.

2. Bob’s Computers, a computer retailer, has historically used FIFO (First-In,

first-Out.) for valuing its inventory. In the last few years, Bob’s has become
quite profitable and Bob’s accountant suggests that Bob switch to the LIFO
(last-in, first-out.) Inventory system to minimize taxable income. According
to the consistency principle, Bob can change accounting methods for a
justifiable reason. Whether minimizing taxes is a justifiable reason is
debatable.

PART 2: DEFINITIONS
ASSET
An asset is defined as a resource that is owned or controlled by a company that can be
used to provide a future economic benefit and generate future revenues or maintain its
operations.

Pretty much all accounting systems separate groups of assets into different accounts.
These accounts are organized into current and non-current categories.

1. A current asset is one that has a useful life of one year or less. For example:

Cash
Account receivable
Supplies
Notes receivable

2. Non-current assets have a useful life of longer than one year. For example:
Fixed Assets – Fixed assets include equipment, vehicles, machinery, and even
computers.
Intangible Assets – Not all assets are physical. Some assets like goodwill, stock
investments, patents, and websites can’t be touched. There are many more types of
assets that aren’t mentioned here, but this is the basic list.

7
Liabilities
Liabilities: are financial obligations a business owes to other persons, businesses and
governments. There are two types of liability Short- term liability and long-term
liabilities:

Short-term liabilities are financial obligations that become due within a year.
Long-term liabilities are due in a year or longer. A company's total liabilities are the
sum of its short-term and long-term liabilities. Liabilities are reported on a company's
balance sheet along with its assets and owners' equity.

EXPENSES
Expenses: An expense is the cost of an asset used by a company in its operations to
produce revenues. For examples: expenses of salary use of supplies and advertising,
rent expenses, utilities, rent expenses and insurance services.

INCOME
Income means the earnings a company receives from selling services and goods to
customers and returns on any investments.

There are two types of income:

 Sale Revenue: Income earned in the ordinary course of business
activities of the entity;

 Gains: Income that does not arise from the core operations of the
entity.

EQUITY

Definition: Equity, also called net assets, is the owner’s claim to company assets after
the liabilities are paid off. The equity of a company can be calculated by subtracting

8
the company liabilities from the company assets. This is why equity is commonly
referred to as net assets or residual equity.