Basic accounting concepts

Ø 1) Look at the heading and the words in the table in the text and say what this text is about. Have you ever come across any of these ideas in your profession or life?

Ø 2) Match the concepts and their definitions:

Ø 3) Answer the questions:

a) What do the assets of a business comprise?

b) What assets are not mentioned in balance sheets?

c) When do liabilities arise?

d) What is the difference between revenue and profit?

The establishment of concepts is very important to the development of a theoretical framework. Accounting concepts are used to describe the events that comprise the existence of business of every kind. For this reason accounting is often characterized as “the language of business.” The basic concepts listed in the table below provide the essential material of accounting theory.

Assets are things of value which are possessed by a business. In order to be classified as an asset the money measurement convention demands that a thing must have the quality of being measurable in terms of money. The assets of a business comprise not only cash and such property as land, buildings, machinery and merchandise, but also money which is owed by individuals or other enterprises (called debtors) to the business.

Often the major asset of a highly successful firm is the knowledge and skill created as a result of teamwork and good organization. This asset will not appear in the accounts, since the firm has paid nothing for it, except in terms of salaries which have been written off against yearly profits. So, the value of the human assets of the firm is not mentioned in balance sheets. However, it is universally recognized that the firm’s human assets are its chief source of wealth. Yet, it is only recently that accountants have begun to recognize this fact, and efforts are now being made to find ways in which information on the value of human assets may be most appropriately presented.

There are other important assets of which no mention is made in financial accounting statements, for example, the value of the firm on the market and the value of the firm’s own information system, which affects the quality of its decisions.

Liabilities are the amounts owned by the business. Most firms find it convenient to buy merchandise and services on credit terms rather than to pay cash. This gives rise to liabilities known as trade creditors. Liabilities arise also when a firm borrows money as a means of supplementing the funds invested by the owner. The reason why amounts of money owed to the creditors by a business are known as liabilities is that the business is liable to them for the amounts owed.

Capital is the excess of assets over liabilities and represents the owner’s investment in the business. The assets of a business must always be equal to the liabilities and the owner’s capital. This is the result of double-entry bookkeeping, whereby each transaction has a two-fold effect.

Revenue is earned by a business when it provides goods and services to customers. Whereas a trading business will derive revenue mainly from the sale of merchandise, a business which renders services, such as a solicitor, will derive revenue as a result of charging for the service. It is not necessary for a business to receive cash before recognizing that revenue has been earned. The accrual convention recognizes revenue which arises from the sale of goods or services on credit.

Expenses are incurred in earning revenue. Examples of expenses are wages and salaries paid to employees and rent paid to the landlord. If expenses are not paid when they are incurred the amount is recorded as a liability.

Profit results when the total revenue of a business for a certain period, such as a year, exceeds the total of the expenses for that period. Profit accrues to the owner of the business and increases his investment. The increase is reflected in the owner’s capital, being a liability due to him.

Transactions are events which require recognition in the accounting records. They originate when changes in basic concepts are recorded. A transaction is financial in nature and is expressed in terms of money.

Accounting conventions determine the rules which are applied to accounting procedures. Accounting conventions are continually being adapted to meet the changing demands of business, and at any point in time there may be more than one accepted way of treating a particular class of transaction. A thorough knowledge of these conventions is necessary for a complete understanding of financial statements.

If accountants as a group wish to change some of their conventions, they are free to do so. The term “accounting conventions” serves to underline the freedom accountants have enjoyed in determining their own rules.