Accounting is the language of business and it is used to communicate financial information. In order for that information to make sense, accounting is based on 12 fundamental concepts. These fundamental concepts then form the basis for all of the Generally Accepted Accounting Principles (GAAP). By using these concepts as the foundation, readers of financial statements and other accounting information do not need to make assumptions about what the numbers mean.
For this reason, it is imperative to know and understand the key concepts.
Key Accounting Concepts
Accounts are kept for entities and not the people who own or run the company. Even in proprietorships and partnerships, the accounts for the business must be kept separate from those of the owner(s).
For an accounting record to be made it must be able to be expressed in monetary terms. For this reason, financial statements show only a limited picture of the business.
Accounting assumes that an entity will continue to operate indefinitely. This concept implies that financial statements do not represent a company’s worth if its assets were to be liquidated, but rather that the assets will be used in future operations. This concept also allows businesses to spread (amortize) the cost of an asset over its expected useful life.
An asset (something that is owned by the company) is entered into the accounting records at the price paid to acquire it. Because the “worth” of an asset changes over time it would be impossible to accurately record the market value for the assets of a company. The cost concept does recognize that assets generally depreciate in value and so accounting practice removes the depreciation amount from the original cost, shows the value as a net amount, and records the difference as a cost of operations (depreciation expense.)
To avoid overstatement of income in any one period, the matching principle requires that revenues and related expenses be recorded in the same accounting period.
Once an entity decides on one method of reporting (i.e. method of accounting for inventory) it must use that same method for all subsequent events. This ensures that differences in financial position between reporting periods are a result of changed in the operations and not to changes in the way items are accounted for.
Accounting practice only records events that are significant enough to justify the usefulness of the information. Technically, each time a sheet of paper is used, the asset “Office supplies” is decreased by an infinitesimal amount but that transaction is not worth accounting for.
The bottom-line is that the ethical practice of accounting mandates reporting income as accurately as possible and when there is uncertainty, choosing to err on the side of caution.