Accounting Principles

The business entity concept (also called the separate entity concept) holds that the business is treated as a distinct entity from its owner, even if — legally — a sole trader and their business are the same person.

What this means in practice:

• Only transactions of the business are recorded in the business's accounts.
• The owner's personal assets, liabilities, and expenses are excluded.
• When an owner takes cash or goods from the business for personal use, this is recorded as drawings (a reduction of capital), NOT as a business expense.
• When an owner invests personal money into the business, this is recorded as capital introduced.

Example: Ahmed runs a bakery. He uses $500 of business cash to pay his personal electricity bill at home. Under the business entity concept, this is NOT an expense of the business. It is drawings — Ahmed has withdrawn business money for personal use. If it were recorded as an expense, the business profit would be understated.

Why it matters: without this concept, there would be no clear boundary between business performance and personal finances. Financial statements would be meaningless because they could include any of the owner's personal spending.

The going concern concept assumes that the business will continue to operate for the foreseeable future and has no intention or need to liquidate its assets.

What this means in practice:

• Non-current assets are valued at cost less accumulated depreciation, not at their forced sale (liquidation) value. A machine might sell for $5,000 in a fire sale but is recorded at its depreciated cost of $20,000 because the business will continue using it to generate income.
• Depreciation is spread over the useful economic life of the asset (because the business will use it for years to come).
• Accruals and prepayments are recognised — because the business will continue and these amounts will be received or paid in future periods.

If the going concern assumption is NOT valid (i.e., the business is about to close or liquidate):

• Assets must be revalued at net realisable value (what they would actually fetch in a sale).
• All liabilities become immediately due.
• The basis of accounting changes completely.

Example: A business owns a large specialised manufacturing machine with a net book value of $80,000. If the business is a going concern, it continues to be recorded at $80,000 (cost minus depreciation). If the business is closing, the machine may only fetch $15,000 at auction — that would become its value in the liquidation accounts.

The historical cost concept requires that assets and transactions are recorded at their original cost (the amount actually paid) rather than their current market value.

Why use historical cost?

• It is objective and verifiable — the purchase price is documented by invoices and contracts.
• Current market values are subjective — different valuers may give different estimates; they fluctuate daily.

Limitations (examinable):

• Asset values in the statement of financial position may be significantly different from their current market value, especially after many years.
• Land and buildings purchased decades ago may be worth far more than their recorded cost.
• This makes comparisons between businesses (inter-firm comparison) and capital employed calculations unreliable.

Example: A business purchased land for $100,000 in 2005. By 2025, the land is worth $800,000 on the market. Under historical cost, the accounts still show it at $100,000. Capital employed is understated by $700,000, which means ROCE (Net profit ÷ Capital employed) is overstated.

Note: The historical cost concept is closely related to the objectivity principle — prefer objective, verifiable figures over subjective estimates. However, some businesses do revalue assets (particularly land) and record a revaluation surplus in reserves — this is an exception to strict historical cost.

The accruals concept (also called the matching concept) states that revenues and expenses should be recognised in the accounting period in which they are earned or incurred, regardless of when the cash is actually received or paid.

Matching principle: expenses are matched against the revenue they helped to generate in the same period.

Consequences — what the accruals concept creates:

1. Accruals (accrued expenses): expenses incurred during the period but not yet paid (e.g., wages owed at year end). These must be added to expenses in the income statement and shown as a current liability in the statement of financial position.

2. Prepayments (prepaid expenses): expenses paid in advance that relate to the next period. These must be deducted from expenses in the income statement (they are not yet "used up") and shown as a current asset.

3. Accrued income (income due): revenue earned but not yet received (e.g., interest earned but not yet paid by the bank). Added to income in the income statement, shown as a current asset.

4. Deferred income (income received in advance): cash received for services not yet provided (e.g., rent received for next year). Deducted from income in the income statement; shown as a current liability.

Example: A business pays $12,000 rent on 1 January for the full year. By 31 March (3 months later), only $3,000 worth of rent has been "used up". The income statement shows rent expense of $3,000; the remaining $9,000 is a prepayment (current asset).

The prudence concept (also called conservatism) requires that accountants should:

• Not anticipate profits before they are certain (do not record income until it is earned)
• Do recognise losses and liabilities as soon as they become probable, even if not yet certain

The purpose is to prevent the overstatement of assets, profits, and income — and to ensure that liabilities and losses are not hidden or deferred.

Examples of prudence in action:

1. Provision for doubtful debts: even though the debt has not yet been written off, a provision is created for the estimated amount of trade receivables that may not be collected. This reduces profit and net assets immediately — prudently recognising the probable future loss.

2. Writing off irrecoverable debts: when a debt is certain to be uncollectable, it is written off as an expense immediately rather than being left as an asset.

3. Inventory valued at lower of cost and net realisable value (NRV): if inventory has fallen in value below its cost (e.g., due to damage, obsolescence, or market price fall), it is written down to NRV. It is never written UP to a higher value, even if market prices rise above cost.

4. Not recording contingent assets (possible future income) in the accounts unless they are certain.

5. Disclosing contingent liabilities (possible future losses) in notes to the accounts even before they are confirmed.

Tension with neutrality: modern accounting standards (IFRS) emphasise that prudence should not lead to excessive caution or bias — accounts should be neutral, presenting a faithful representation. However, the essential idea that losses are recognised promptly while profits are not anticipated remains central.

The consistency concept requires that, once a business has chosen an accounting policy or method, it should continue to apply the same method consistently from one accounting period to the next.

Why consistency matters:

Financial statements are most useful when they can be compared over time. If a business changed its depreciation method every year, or switched between FIFO and AVCO for inventory valuation, the year-on-year changes in profit and asset values would reflect accounting policy changes rather than actual trading performance. It would be impossible to tell whether a change in gross profit margin was due to better trading or a change in accounting method.

What consistency does NOT mean:

• A business can change its accounting policy if there is a good reason (e.g., a change in accounting standards, or a change that gives a fairer presentation of results).
• When a change IS made, it must be disclosed in the notes to the accounts, and comparative figures must be restated if possible so that users can understand the effect of the change.

Example: A business has used straight-line depreciation for machinery for five years. It now switches to reducing balance. Under the consistency concept, this change must be:

1. Disclosed in the notes (explaining why the change was made)
2. The effect on profit explained (reducing balance gives higher depreciation charge in early years, reducing profit)
3. Prior year figures may need to be restated for comparability

Exam scenario: 'Explain why the change in depreciation method means that this year's profit margin cannot be reliably compared with last year's.' Answer: the consistency concept has been violated — the change in method makes it impossible to determine whether the profit margin change reflects trading performance or merely the different depreciation calculation.

Materiality Concept

An item is material if its omission or misstatement could influence the decisions of users of the financial statements. Only material items need separate, detailed disclosure.

• A large company might treat a $500 expense as immaterial and group it with other minor costs, even though accounting rules would normally require detailed treatment.
• A stapler costing $8 could theoretically be capitalised as a non-current asset (it will be used for more than one year). But it is immaterial — it is written off as an expense immediately.
• What counts as material depends on the size of the business and the size of the amount relative to total assets and profit.

---

Dual Aspect (Duality) Concept

Every transaction affects at least two accounts, with equal debit and credit entries. This is the foundation of double-entry bookkeeping and the reason the accounting equation always balances:

$\text{Assets} = \text{Capital} + \text{Liabilities}$

Example: Purchase equipment for cash → Equipment (asset) increases; Cash (asset) decreases. Two equal and opposite effects.

---

Money Measurement Concept

Only transactions that can be expressed in monetary terms are recorded in the accounts. This excludes:

• Staff morale, loyalty, and expertise
• Brand reputation
• Customer relationships
• Quality of management

Limitation: the most important drivers of a business's future success may be entirely invisible in its financial statements.

---

Realisation Concept

Revenue is recognised (recorded) when it is earned — typically when goods are delivered or services are performed — NOT when cash is received.

Example: A business completes a $10,000 consulting project in December but is not paid until January. Under realisation, the $10,000 is recorded as income in December (when earned), not January (when the cash arrives). This creates an accrued income balance at year end.