What are the Basic Accounting Concepts?

There are a number of conceptual issues that you must understand in order to develop a firm foundation regarding how accounting works. Without these concepts, it will be difficult to progress to a knowledge of more advanced concepts, such as the structure of an accounting system or how to produce financial statements.

These basic accounting concepts are noted below.

Accruals Concept

Under the accruals concept, revenue is recognized when earned, and expenses are recognized when assets are consumed. This concept means that a business may recognize revenue, profits and losses in amounts that vary from what would be recognized based on the cash received from customers or when cash is paid to suppliers and employees. Auditors will only certify the financial statements of a business that have been prepared under the accruals concept. Any larger organization will use the accruals concept.

Conservatism Concept

Under the conservatism concept, revenue is only recognized when there is a reasonable certainty that it will be realized, whereas expenses are recognized sooner, when there is a reasonable possibility that they will be incurred. This concept tends to result in more conservative financial statements. This is an essential concept that can prevent you from producing excessively optimistic financial statements.

Consistency Concept

Under the consistency concept, once a business chooses to use a specific accounting method, it should continue using it on a go-forward basis. By doing so, financial statements prepared in multiple periods can be reliably compared. This is an essential requirement for financial analysis, where you are routinely comparing the results and financial positions of a business for multiple reporting periods.

Economic Entity Concept

Under the economic entity concept, the transactions of a business are to be kept separate from those of its owners. By doing so, there is no intermingling of personal and business transactions in a company's financial statements. This is a problem area for small businesses, such as sole proprietorships, where the business may be operated using the owner’s personal checking account. In these cases, it can be extremely difficult to determine which transactions are associated with the business.

Going Concern Concept

Under the going concern concept, financial statements are prepared on the assumption that the business will remain in operation in future periods. Under this assumption, revenue and expense recognition may be deferred to a future period, when the company is still operating. Otherwise, all expense recognition in particular would be accelerated into the current period. This concept is not usually a major concern - only when a business is getting close to being insolvent.

Matching Concept

Under the matching concept, the expenses related to revenue should be recognized in the same period in which the revenue was recognized. By doing this, there is no deferral of expense recognition into later reporting periods, so that someone viewing a company's financial statements can be assured that all aspects of a transaction have been recorded at the same time. This is an essential issue, since it prevents related expenses from being dribbled out on a firm’s income statement over an extended period of time, making it difficult to decide whether the business is actually earning a profit.

The matching concept is a core issue when you are using the accrual basis of accounting, and is the reason why many accrual journal entries are recorded. Conversely, this concept is routinely violated when you are using the cash basis of accounting, where revenue is recorded when cash is received, and expenses are recorded when cash is paid out.

Materiality Concept

Under the materiality concept, transactions should be recorded when not doing so might alter the decisions made by a reader of a company's financial statements. This tends to result in relatively small-size transactions being recorded, so that the financial statements comprehensively represent the financial results, financial position, and cash flows of a business. This can turn into an accounting efficiency issue, since recording too many very small transactions can waste a large amount of time.