There are a number of conceptual issues that one must understand in order to develop a firm foundation of how accounting works. These basic accounting concepts are as follows:
- Accruals concept. Revenues are recognized when earned, and expenses are recognized when assets are consumed. This concept means that a business may recognize sales, 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.
- Conservatism concept. Revenues are only recognized when there is a reasonable certainty that they 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.
- 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, the financial statements prepared in multiple periods can be reliably compared.
- 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.
- 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.
- 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.
- 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.