Financial accounting concepts are basically rules and regulations that are meant to guide the way records are kept, interpreted and analyzed. They are the basic principles used in the preparation of financial statements. We can say it is a backbone on which financial statements are built.
Financial accounting concepts can also be called axioms, percepts, postulates, practices, assumptions, and principles. Some of the concepts which guide the preparation of financial statements include:
a) Historical cost concept: The historical cost concept requires that figures recorded are recorded on historical basis rather than current value basis. This means that when recording transactions, for example the value of an asset in later years, we record based on the nominal or original cost the company acquired the asset, even if the asset might have appreciated in value.
b) Monetary concept: Monetary concept in accounting requires transactions to be measured in “money terms” only. Why choose money? The simple reason is that everyone understands the value of money, and once an asset is measured in money terms, users easily know what the asset is worth. It is worthy of note that transactions are recorded using the local currency of the country where the financial statements are prepared. This means that financial records kept in the united states of America (USA) are recorded in Us dollars, while financial records kept in Nigeria are recorded in Naira.
c) Going concern concept: This concept requires financial statements to be prepared as if there is no end to the business, and like God himself, the business would live forever. The going concern concept assumes that the entity has no intention of liquidation or discontinuing any part of its operation within the foreseeable period.
d) Periodicity concept: The concept believes that the company must have time intervals (accounting period) over which the business finds out whether or not the profit making objective of the business is achieved. Secondly, the periodicity concept requires that all revenues and gains must be recorded in the accounting period in which they are earned, and all expenses and losses also recorded in the period in which they are incurred regardless of when cash for the revenue or gain is received or cash for the expense or loss is paid.
e) Business entity concept: The business entity concept states that the business should be seen as a separate entity, distinct from the owners of the business. This means that transactions associated with a business must be separately recorded from those of its owners. Hence the assets and claims over the asser of the business, its expenditures and income are quite different and separate from that of the business.
f) Accrual concept: Accrual concept states that revenue and expenses are recorded in the period they occur whether or not cash is received or paid respectively. When recording revenue based on the accrual concept, we record income earned and not cash received. To derive income earned we say:
Income earned = Income received + Income due but not yet received – Income received but not yet due.
Note that income received but not yet due is unearned income. This means that a company is paying you upfront for a service you would still render to him at a later date.
When recording expenses for the period we record expenses incurred and not expenses paid. To derive expenses incurred we say:
Expenses incurred = Expenses paid + expenses due but not yet paid – expenses pain but not yet due (Ie prepayment)
The accrual concept is responsible for spreading income and expenses to ensure that they relate to their appropriate periods. Read more on accruals
g) Matching concept: The purpose of a profit or loss statement is to ascertain whether the business made profits or losses in an accounting period. To prepare a profit or loss statement, expenses incurred would be taken away from income earned to determine if the business made a profit or loss in that accounting period. The matching concept requires that a period’s revenue is reported along with the expenses that brought them, and when calculating profit or loss, expenses for a period are matched with the revenues of the same period.
h) Recognition or realisation concept: Realisation concept requires that the revenue be recognized once the underlying goods or services associated with the revenue have been delivered or rendered. Likewise, an expense should be recognized once the underlying goods and services associated with the expense is delivered or rendered even before making cash payments, or when there is a degree of certainty that expense would be incurred.
The above means that a letter of intent or request for invoice from a prospective buyer doesn’t count as revenue. The realization concept identifies the point at which the business organization can be held responsible for expense, and the point at which the business is entitled to income.
i) Double entry: This rule guides the way in which transactions are recorded. It requires transactions to be recorded twice. One record is to be mad on the left hand side of an account while the other is to be made on the right hand side of another account. The record on the left hand side is known as a debit entry, while the record on the right hand side is known as a credit entry. Read more on double entry accounting.
Joel Lerner., Raul Gokam., Schaum’s outline of Book keeping and Accounting