The New Year is just around the corner and now is the time to start thinking of new accounting approaches to use in January. In order to understand how accounting works, one must be familiar with basic accounting concepts. These concepts build the basic foundation of modern accounting. So what are the basic accounting concepts? Here’s a look at each one and what they mean
With the accruals concept, revenue is recognized only when it is earned. Expenses are only recognized when assets are consumed. Auditors will only certify accounting statements that are created under the accruals concept.
Here’s an example of how the accruals concept works: A business will only recognize revenue when the company receives payment for a product or a service. A business will only recognize an expense when a payment is made to a vendor.
With the conservatism concept, revenue is only recognized when there is a reasonable certainty that it will be realized. On the other hand, expenses are recognized sooner. This is a more conservative approach to accounting.
Here’s an example of the conservatism concept: A business will recognize revenue only when the payment has been received for a product or service. However, an expense will be recognized when a bill or invoice has been received by the business.
With the consistency concept, a business will stick with whatever accounting method that they use going forward. This removes confusion over the long term. For instance, if a company decides to use accrual accounting, then it will continue to use accrual accounting throughout the life of the business.
Economic Entity Concept
With the economic entity concept, the transactions of a business are kept separate from the business of its owners. That means that there is no intermingling of the business owner’s finances with that of the business itself.
Here’s an example of the economic entity concept: A business owner has a bank account for both his own personal finances and the business has a bank account for its own transactions. At no time do finances cross between the two accounts unless the business is paying the owner a salary?
Going Concern Concept
With the going concern concept, financial statements are prepared with the assumption that the business will continue to remain in existence. Using the going concern concept, revenue and expenses can be deferred into the future.
An example of a going concern concept is that expense recognition for a business can be deferred into the new tax year for tax efficiency purposes.
With the matching concept, revenue is recognized during the same period that it is realized. In this case, there is no deferral of revenue into a later period.
An example of a matching concept is that all revenue in the third quarter of a business year is recognized during the third quarter of that year in financial statements.
Materiality concept defines what is important when it comes to a company’s financial reporting. For instance, if a company does not report certain revenue during a period that it occurred, then this omission may have a material impact on how the financial statements are perceived.
Why are Accounting Concepts Important?
There are a number of reasons why accounting concepts are critical to the everyday recording of financial information.
1). Avoids confusion
With accounting concepts in place, it keeps financial reporting and accounting more organized. This can come in handy when it comes time to audit a business.
2). Makes it easier to analyze a company
If a company wants to sell itself to a buyer, accounting concepts will make it easier for the potential purchaser to understand how the business operates.
3). Faster accounting
With a basic accounting concept in place, it will be easier for accountants to record relevant information. This can be helpful as a business grows and increases its number of transactions.
Understanding Basic Accounting Concepts
Whether you run your own business or you need to understand the basic financial operations of a business entity, it is important to understand and use basic accounting concepts. By having a familiar grasp of basic accounting concepts, it will be easier for you to read financial statements and make better-informed decisions about a business. For more education on the basic accounting concepts and more, MBA Financial and Accounting Solutions can help you set a firm foundation going into 2022. Contact us today at 800-576-5746 for more accounting concepts!