Principles and concepts of accounting

Learning outcome A1 from the FA2 syllabus is related to ‘The key principles, concepts and characteristics of accounting’. This learning outcome causes difficulties for some candidates. These difficulties may arise because the learning outcome is more theoretical than other parts of the syllabus and tends to be examined in narrative style questions, which some candidates may find more difficult than calculation-based questions.

It is important to note that the principles and concepts of accounting are distinct from the ‘qualitative accounting characteristics’ and this differentiation is clearly set out in the Detailed Study Guide (‘the study guide’).

The focus for this article is the principles and concepts of accounting.  There is a complimentary FA2 article titled ‘Qualitative accounting characteristics’ (see 'Related links') which provides more detail on the qualitative accounting characteristics.

Principles and concepts of accounting

For the purposes of the FA2 exam, there is a list of principles and concepts of accounting which you need to be familiar with and which can be found in learning outcome A1(a) in the study guide:

  • Going concern
  • Accrual basis
  • Materiality
  • Consistency
  • Prudence
  • Duality (dual aspect)
  • Business entity
  • Historical cost

What candidates need to know about each of these is:

  1. how it is defined, and
  2. how it should be applied.

Each of these principles and concepts are considered below. Where a formal definition is provided by the Conceptual Framework for Financial Reporting (the Conceptual Framework), that definition is given, followed by an elaboration of the key points of that definition that candidates need to understand.

Going concern

Definition: ‘Financial statements are normally prepared on the assumption that the reporting entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to enter liquidation or to cease trading. If such an intention or need exists, the financial statements may have to be prepared on a different basis. If so, the financial statements describe the basis used.

The basic point about the going concern principle is that it is assumed that the entity will continue to operate for the foreseeable future. For FA2, candidates do not need to consider the time period that might be regarded as the ‘foreseeable future’. This is an advanced issue that will be considered in later exams. The same can be said of issues such as:

  • circumstances in which the going concern assumption might not apply;
  • what different basis could be used; and
  • who decides whether the going concern assumption should apply.

While an awareness of what is meant by ‘a different basis’ might be expected (for example, break up basis), candidates would not be expected to apply that basis to calculate values in the FA2 exam.   

Accrual basis

The Conceptual Framework refers to ‘accrual accounting’, also known as ‘the accruals concept’ or simply as ‘accruals.’

Definition: ‘Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period.’

Essentially, what accrual accounting means is that the date on which cash is paid or received is often not necessarily the same as the date that the actual transaction takes place, but this should not delay the transaction being recorded. In transactions between businesses, it is common for payment not to be made on the same date that an order is made or that goods are transferred.

Although the definition might seem a little complicated at first reading, this is essentially a simple idea. If Andrea agrees to buy goods from Brian on 25 January and Brian agrees that Andrea can wait until 25 March to actually pay for the goods, accrual accounting requires that the transaction is recorded when the sale/purchase takes place rather than when cash changes hands. Thus, the initial sale and purchase transaction is recorded on 25 January.

Accrual accounting means that the accounting records will include balances for receivables (amounts that the entity expects to receive in the future as a result of past transactions) and payables (amounts that the entity expects to pay out in the future as a result of past transactions). When preparing financial statements, it will be necessary to recognise any costs that have been paid, but not yet consumed (prepaid expenses), as well as costs that have been consumed, but not yet paid for (accrued expenses).

It is worth remembering that, while a number of the theoretical aspects of the syllabus are linked in the same way as has been noted above, candidates should ensure that they understand the key points of each principle or concept in isolation first of all. Once a good understanding has been developed at an individual level, it will be easier to make the links between the various principles and concepts.

Materiality

Definition‘Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial reports make on the basis of those reports, which provide financial information about a specific reporting entity.’

There are some key issues within this definition that candidates should be aware of.

The first is that materiality is different to complete accuracy. For example, we can see this in practice in the published financial statements of large businesses. These often report values in $000 or $m. While the exact values to the single dollar are not communicated, the essential (material) information is provided as an aid to decision making.

This leads to the second issue – materiality is related to the fact that the purpose of financial statements is to provide information so that it can be used to make decisions about whether to undertake transactions with a particular entity. So reporting to the nearest $000 or $m instead of the nearest $, will often still allow informed decisions to be made.

The final issue is that materiality is affected by both:

  1. whether information is included or omitted from financial statements, and
  2. whether it is sufficiently informative.

It is not necessary, and often not helpful, to simply include as much detail as possible in the financial statements. Consideration should be given to the fact that excessive detail may not actually improve presentation and therefore not assist users of financial statements. For example, important information could be obscured by including it among large amounts of insignificant detail.

Candidates in FA2 will not be required to decide on an appropriate cut off level for materiality. This is a more advanced issue, which requires the exercise of professional judgment.

Consistency

Definition: ‘The use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities.’

Consistency is a straightforward principle and is intended to enhance financial reporting by making it easier for users to make comparisons. In that sense it contributes to the achievement of comparability which is one of the qualitative characteristics of useful financial information (see the related article ‘Qualitative accounting characteristics’).

By requiring similar items to be treated in the same way, this contributes to making comparisons more meaningful.

Consistency should be applied in two ways:

  1. ‘from period to period’ – ie by a single entity, and
  2. ‘across entities’ – ie between entities in the same period.

In practical terms, this means that consistency helps to achieve comparability. For instance, it should be possible for users to understand how a business has performed in the year by comparing it to the results of the previous year. This is only possible if the figures and information are prepared using consistent methods across each year. Consistency across entities means that it should be possible to compare one business’s performance with a competitor and therefore make informed investment decisions.

This does not mean that everything in the accounts needs to be treated the same by every entity.

Prudence

Definition‘The exercise of caution when making judgements under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated. Equally, the exercise of prudence does not allow for the understatement of assets or income or the overstatement of liabilities or expenses.’

There is often uncertainty about the eventual outcome of certain events and transactions. This means that estimates need to be made when preparing financial statements. Prudence requires that, whenever such uncertainty exists, preparers of financial statements take a careful approach to the figures and information that they include in the financial statements.

Arguably, the biggest risk in this regard is that a business will be inclined to be optimistic about results and therefore overstate assets and income or understate liabilities and expenses. There could be financial incentives for business owners to do this and therefore the prudence principle must be observed to ensure this does not happen.

Equally, preparers should not be ‘overly prudent’ to the extent that they pick the lowest possible outcome simply to avoid the risk of overstating assets and income or understating liabilities and expenses. This would still not provide a fair presentation of the financial position or financial performance of the entity and, therefore, it is  important that caution is exercised to avoid this as well.

Duality (dual aspect)

‘Duality’ refers to the fact that every transaction has a ‘dual aspect’ and therefore requires the use of ‘double entry’ accounting. Double entry is often easier to do than to explain. For this reason, candidates would be wise to complete as many practice questions as possible before taking the exam. It is also the reason why the topic can only be touched on briefly in a short article such as this.

There is no definition of double entry in the Conceptual Framework – although it is probably fair to say that this is the most fundamental underpinning principle in accounting. In the absence of a formal definition, it is best to start by understanding the term ‘dual aspect’. The dual aspect means that each party in a transaction is affected in two ways by the transaction and that every transaction gives rise to both a debit entry (Dr) and a credit entry (Cr).    

Given that the value of the debit entries is the same as the value of the credit entries for any given transaction, it follows that when a number of transactions have been recorded, the total value of the debit entries will still be the same as the total value of the credit entries. This is the basis of the accounting equation.

All of this can be explained by considering the transaction that was included in the discussion on accruals. This was that Andrea agrees to buy goods from Brian on 25 January and Brian agrees that Andrea can wait until 25 March to pay for the goods.

This straightforward example allows a key point about double entry to be made. Clearly there are two parties involved in the transaction. While both parties will record the transaction, that is not what is meant by double entry. It is important to remember that when preparing accounting entries, we are only dealing with a single entity – either Andrea or Brian.

From Andrea’s point of view the dual aspect is:

  • she has obtained goods, and
  • she has also incurred the responsibility to pay for the goods at a later date. 

In a real-life situation (and in an exam question), it will be clear whether the goods have been bought with the intention of selling them at a profit, or if they have been bought for consumption/use within the business. For the moment, let’s assume that Andrea has bought the goods for resale. That means we can now identify the two accounts in which entries will be made:

  • goods for resale (or ‘purchases’ as is more often used to describe this account), and
  • trade payables.

The next step is to decide which account will have the debit entry and which will have the credit entry. One way of doing this is to use a memory AID. The upper-case letters have been used because the word itself is the AID – Asset Increase Debit.

This AID reminds us that, if an asset has been increased, then a debit entry is required. The AID can be expanded by changing one element within it at a time to the opposite state, leading to the opposite entry:

Asset decreasedCredit
Liability increasedCredit


It can therefore be deduced that:

Liability decreasedDebit

Using this logical approach, it should be possible to identify which accounts will be affected and then consider how they will be affected.

Thus, if Andrea has incurred the responsibility to pay for the goods, she has clearly increased a liability. That means a credit entry is required in her trade payables account. It follows that the entry in her purchases account will be a debit.

Business entity

The business entity principle simply means that, for the purpose of maintaining accounting records, the business is treated as a separate entity from the owner(s) of the business. The Conceptual Framework refers to a ‘reporting entity’ which is an entity that is required, or chooses, to prepare financial statements.

As FA2 only relates to unincorporated businesses (sole traders and partnerships), this might seem like an unrealistic differentiation. However, a business entity is not necessarily a separate legal entity and candidates should simply deal with transactions from the perspective of the business.

In our example, Andrea has been identified as the owner of the business. As she is a sole trader (ie her business is unincorporated), there are some important legal points to be noted. The first is that there is no legal differentiation between Andrea and her business. Following from that, Andrea will be personally responsible for any debts that the business incurs, and her personal assets may be used to settle business debts.

However, her personal assets are not included in the business records. In addition, if Andrea withdraws money for personal expenses, the nature of the expense is not recorded. All that is necessary is to record the fact that Andrea withdrew funds – with a debit entry in the drawings account and credit entry in the bank account. 

Historical cost

Theoretically, there are a number of bases that could be used to derive the value at which transactions are recorded. However, historical cost is the only one of these that needs to be considered in the context of FA2.

Definition: ‘Historical cost measures provide monetary information about assets, liabilities and related income and expenses, using information derived, at least in part, from the price of the transaction or other event that gave rise to them.’

In simple terms this means that, for FA2, assets and liabilities will continue to be recorded at the value at which they were initially recorded and that value will be based on the value at the date of the transaction.

The historical cost of assets and liabilities will still be updated over time to depict accounting transactions like depreciation or the fulfilment of part or all of a liability. But it will not be updated to reflect the current value of a similar asset or liability which might be acquired or taken on.

Summary

By ensuring that the key points of each of these principles and concepts are understood, candidates should be better prepared to answer questions that might arise in the exam. 

Written by a member of the FA2 examining team