Accounting concepts with examples
If you are looking to get into the world of business, you must first know the basic accounting concepts for beginners.
Whether you’re a freelance worker or an entrepreneur, you need to know the ins and outs of bookkeeping in order to make informed business decisions.
Learning accounting concepts could be daunting.
Particularly, if you are coming from non-accounting background. Even many business students struggle comprehending these concepts. In this article we have discussed all accounting concepts simplified examples to make the comprehension supper easy. Without a further delay, let’s dive into learning the accounting concepts.
Basic accounting concepts every beginner should know
1. Accruals
Accrual focuses on the event of happening, apart from the cash settlement of that particular event. Generally, in normal course of business, you can’t put a cut off on the business transactions easily at any given point of time. Therefore, you need to record your information where the timing difference doesn’t mislead the overall financial position of the company.
Example:
ABC LLC has installed the security cameras of ZXY Limited. On 31 December 2022, ABC Limited has not issued any invoice for the services performed as at 31 December 2022. In this case, the Accrual concept allows ABC limited to record the revenue in its books so that the stakeholders of the business can have the visibility of the job performed as at 31 December 2022.
Similarly, in the books of XYZ Limited, the installation services acquired will be recorded as accrued expense. Irrespective of the payment settlement for the services acquired.
2. Matching
Matching concept ensures that the expenses are recorded should be related to the revenue recorded in a period. The primary objective of matching concept is to get fair view of the financial statements as the expenses are only related to the recorded revenue. The under and overstatement of revenue is avoided by following the matching concept.
Example:
ABC Limited is a real estate company and gives 1% commission to its agents on every sale. In December 2022, the Company made sales of USD 500,000. However, the commission of USD 5,000 will be paid to the agents in January 2023. The matching concept ensures that the commission amount has to be recorded in the month of December 2022 so that the related expense is recorded to give more realistic view of the financial performance of the company.
3. Going Concern
Going concern is basically an assumption which shows that the business will continue to operate to the foreseeable future, or at least in next 12 months. There are various factors which can challenge this concept. For instance, the management itself can decide to wind up the business. Or there could be change in laws and regulations which prevent the business to operate in a economic.
Example:
ABC Limited manufactures plastic bags. The local government imposes ban on the sale of plastic bags. The Company has no other line of business but to sell plastic bags. Under these circumstances, ABC limited has no choice but to liquidate the business. Therefore, the company failed to assert the concept of going concern.
4. Consistency
Consistency principle ensures that the basis of financial statements such as accounting policies, principles, procedures and methodologies are consistent with the previous years. It is done to ensure the reader can easily compare the current year financials with the previous years.
Example:
ABC Limited used to valuing its inventory on the basis of First in First out (FIFO) method. However, the management decided to use the flipside approach i.e., Last in Last out (LIFO). The reason behind this shift was the increase in material cost. Therefore, adopting LIFO approach gives the more accurate financial position of the company. In this case the company is allowed to shift its approach, however, this shift in policy should be disclosed in the financial statements.
5. Materiality
Materiality is anything which can impact the reader’s decision if certain information is omitted or misstated. The concept is totally relative and depends on the volume and nature of the information.
Example:
ABC Limited is a UK based company. All business transactions are recorded in GBP. During the year, the company hired graphic designing services. The total cost of this service was USD 100. In this case, the company is not required to apply IAS 21 which deals with effects of changes in foreign currency rates. As the amount of foreign currency is so minimal.
6. Conservatism/ Prudence Principle
Conservatism principle requires to record liabilities as soon as discovered. On the contrary, the revenues should be recorded when realized. This concept ensures that there should be high level of verification done before claiming any profit. Assets should not be overstated and liabilities should not be understated.
If there is an equal chance of incurring a loss and profit, then the loss should be recorded and profit should be deferred unless it’s realized.
Example:
ABC Limited has secured a contract which allows it to become the sole supplier of kitchen products to a famous restaurant chain. The prudence concept restricts the company to recognize the revenue unless the company starts making sales to the restaurant chain.
Similarly, ABC Limited gives leave encashment benefit to its employees. As of now not a single employee has applied for the leave encashment. Conservatism concept requires the company to make a provision in its books to show the probable chances of an expense in case the employee applies for this benefit.
7. Economic Entity
This is the most fundamental assumption of making the financial statements. Economic entity demands that the entity should be treated a separate ‘person’. The objective of this assumption is to keep the owner’s or shareholder’s activities separate from the entity. Economic entity concepts helps the reader to assess the performance of the company more accurately.
Example:
Mr. Alex invested USD 100,000 in its company Alex LLC. While making the financial statements, Alex LLC will record the capital invested in its credit side along with the company’s liabilities. Since Alex LLC is solely owned by Mr. Alex, this capital should have been recorded as asset (if we see from Mr. Alex perspective). However, as Alex LLC is treated as separate economic activity, therefore, the capital invested will be shown as obligation to the owner (Mr. Alex). Because the entity is required to pay back this capital to its owner.
8. Accounting equation
Accounting equation requires that the company’s assets are equal to its capital and liabilities.
Assets = Capital + Liabilities
This equation shows how the company assets are being financed. The foundation of the financial statements is double entry system. It helps the company to track all financial activities. It starts right from the beginning of investing capital.
Example:
Mr. Alex invested USD 100,000 in Alex LLC. The entry would be:
- Dr Cash at bank (Asset) USD 100,000
- Cr Capital (Capital account) USD 100,000
Alex LLC acquired a loan from a bank of USD 30,000
- Dr Cash at Bank (Asset) USD 30,000
- Cr Loan (liability account) USD 30,000
Now Alex LLC has assets worth of USD 130,000 and capital USD 100,000 and a liability of USD 30,000. The accounting equation will always be balanced.
Asset (USD 130,000) = Capital (USD 100,000) + Liabilities (USD 30,000)
Final words
As an entrepreneur, you may be tempted to skip straight to the fancy financial statements and spreadsheets. But without knowing the basis of the preparation of the financial statements, you may struggle in understanding the amounts. We hope that the above mentioned basic accounting concepts for beginners would help you in better understanding of the financial information of any company.