When you run a business, it’s important to have a clear and documented record of all your financial data. This includes your revenue, expenses, assets, liabilities, overhead costs, and equity. The only way to ensure consistent, accurate, and reliable control in this sense is by using defined accounting concepts. Understanding these basic concepts of accounting also helps you stay compliant with GAAP and IFRS accounting standards and ensures you are able to make enhanced strategic financial decisions.
Today we are going to explore all the accounting concepts that you need to be aware of. This will help you determine the best accounting process for your business. Ultimately, though, all the “concepts” below help you maintain control and transparency in your accounting process so that you can build a profitable and successful business.
We will also discuss how using software such as Factorial’s financial workspace tool can help you streamline the process so that you have access to accurate and reliable data at all times.
What are accounting concepts?
Organizations have a responsibility to maintain and present accurate records that reflect the financial health of their business. These records must take into account all financial aspects of a business. This includes revenue, expenses, assets, liabilities, overhead costs, and equity. This data serves as a reflection of a business’s profits and losses and the value that the organization holds for shareholders and investors.
The format you use to manage your accounting process and report your financial data will vary depending on the regulatory and reporting requirements of the country or region where you are based and where you operate. For example, companies operating in the US must follow the Generally Accepted Accounting Principles (GAAP). Furthermore, if a business operates internationally, it must also comply with International Financial Reporting Standards (IFRS).
The standards you follow will also depend on whether you are a private or publicly owned entity. For instance, private companies in the US are not required to publicly report their financial data. However, both private and public entities must file financial statements with their Secretary of State. They must also file quarterly tax estimates with the Internal Revenue Service (IRS) and an annual tax return with all financial data for the year.
Regardless of reporting requirements, it makes good business sense to follow a standardized format for your accounting process. This is because you have a defined system to clearly document and report all your business transactions.
And this is what accounting concepts, also known as accounting principles, aim to do. Put simply, basic concepts of accounting are uniform standards that businesses use to organize their financial transactions. That way, all financial data can be easily interpreted and clearly integrated into a company’s accounting process.
Benefits of using accounting concepts in your business
So, what are the benefits of using accounting concepts in your business?
Essentially, accounting concepts:
- Serve as a uniform set of rules so that all businesses follow universally accepted standards when they prepare their financial statements.
- Enable you to maintain accurate records of all your financial data that you can report to shareholders and investors.
- Help you avoid potential disputes, discrepancies, and claims of fraud or financial mismanagement.
- Help you better predict the future financial health of your business so that you can make smarter and more strategic financial decisions.
- Ensure your business stays compliant with reporting and regulatory institution obligations.
11 Accounting concepts businesses should understand
Let’s take a look now at 11 accounting concepts that you need to be aware of. Whether you are a sole proprietor or a public or private entity, these basic concepts of accounting help you maintain standardized records of all your financial transactions. For this reason, even if you use software to manage your accounting process, it’s important that you understand all the “concepts” below.
Accruals accounting concept
The accruals accounting concept is a fundamental principle that guides how you record all your cash and credit transactions. With this concept, you keep a record of each transaction according to the period in which it occurs (regardless of when you pay or receive funds related to the transaction). In other words, in the case of expenses, you record when you confirm the purchase, not when you pay the supplier.
Although many small businesses start out using a cash accounting concept (where your statements only reflect income when received and expenses when paid), most organizations eventually switch to accruals accounting for recording all data related to all income, expenses, liabilities, and receivables. This is because you get a much better understanding of your organization’s financial situation. Moreover, all modern accounting systems follow the accruals concept for recording financial transactions of this type. This is because it makes it much easier to report data in a uniform and standardized format. Plus, in the case of publicly owned companies, the GAAP requires these organizations to follow accrual accounting practices.
Conservatism accounting concept
With the conservatism accounting concept, you treat revenue and expenses in different ways. This is what’s known as a double entry system of accounting.
Essentially, with this principle, you separate and record two aspects of the same transaction. You record expenses as soon as they are approved (when there’s a reasonable possibility that each expense will be incurred). However, you only record the revenue aspect when you are reasonably certain that an expense will be realized (e.g. when you receive a purchase or signed invoice).
This method works better in terms of cash flow as it usually results in more conservative financial statements where you are able to overestimate your expenses rather than your revenue.
Economic entity concept
The economic entity concept of accounting requires that you separate business and personal funds. In other words, you should avoid charging personal expenses to a business credit card.
The aim of this accounting process is to simplify financial statement recordkeeping so that there is a clear breakdown of all business transactions, and the business is independent of its owner. This is particularly important in the case of corporations and limited liability companies. This is because failing to maintain a clear separation between personal and business expenses, income, liabilities, and assets can result in legal claims of non-compliance.
This standard also protects the personal finances of business owners and safeguards their financial credibility. Moreover, maintaining a clear distinction enables stakeholders and creditors to make strategic decisions based on the performance of a company rather than the personal financial position of its owner.
Consistency accounting concept
The consistency accounting concept is an approach that aims to maintain consistency throughout all company accounting records. Essentially, this means that once you have adopted an accounting method for documenting and reporting your financial data (accrual or cash), you must use it consistently going forward.
This includes the accounting method you use to create and report your:
- Financial statements
- Cash flow statements
- Balance sheets
- Profit & loss statements
- Accounts payable reports
- Accounts receivable reports
By ensuring consistency in this way, it is much easier for you to access accurate information, compare performance, identify trends, and monitor your financial status over time. Consistency is also a legal requirement for filing small-business taxes with the Internal Revenue Service.
Going concern concept
The going concern concept (also referred to as the continuing concern concept) is best suited to businesses that are assumed to remain operational for the foreseeable future (usually around 12 months from the end date of the reporting period). This is because certain expenses and revenues can be deferred to future accounting periods if necessary. Long-term financial standing is therefore necessary. This includes the ability to meet business objectives, maintain the value of assets, and continue to meet financial obligations.
Going concern is not an advisable principle for businesses that are experiencing financial difficulties or scaling down business operations. This includes companies that are:
- Unable to raise credit from banks and financial services
- Unable to pay dividends
- Not in a position to repay debts
- Facing losses and negative operating cash flow
- In an adverse financial position
- Facing legal or regulatory action
Matching accounting concept
The matching accounting concept is one of the fundamental Generally Accepted Accounting Principles (GAAP). It is based on the cause-and-effect relationship between expenses and revenue. With this concept, you must match incurred expenses against associated revenues.
For example, if you pay an employee a commission for a sale that they closed in March, you need to record it as a March expense (not defer to a later reporting period). That way, there is clear accountability and transparency. Essentially, this concept makes it easier to correlate expenses with their associated earnings.
Materiality accounting concept
Materiality accounting helps you keep track of all financial transactions that could have a material impact on business decisions. The aim is to record all transactions (including small material expenses) so that you get a complete and comprehensive analysis of the financial health of your business.
The materiality account concept is particularly effective if you regularly provide investors with business reports. This is because you can give a comprehensive analysis of every level of spending in your company. This concept also ensures you are prepared for any potential investigations or audits as you have a documented log of all material expenditures. That way, you have a true reflection of your financial results, financial position, and business cash flow.
This approach establishes a number of guidelines for determining if a transaction should be considered material. For example, the materiality principle states that you cannot exclude a transaction if the net impact of doing so negatively misleads a third party’s understanding of a financial statement.
The fundamental accounting equation, also known as the balance sheet equation, is a basic formula used to represent the relationship between a business’s assets, liabilities, and equity. This accounting concept is the foundation for the double-entry bookkeeping system.
The equation is as follows:
Assets = Liabilities + Equity
This method of accounting, considered the most basic of all accounting concepts, helps you understand how your assets are financed and distributed between debts and equity. This can be a particularly useful concept if you are looking to secure further investment or open up additional credit lines. It can also be an effective principle if you need to demonstrate your company’s liquidity, leverage, financial capacity, and growth to other external parties, such as shareholders. Moreover, this concept relies on a very basic formula. This makes it very easy for regulators and the general public to understand your financial statements (particularly important for publicly owned entities).
Account period concept
With the accounting period concept, you define a specific time period for reporting your financial records. This can be any period of time, such as a month, a quarter, or calendar year. Once you’ve defined your accounting period, all transactions conducted during that time must be included in your financial statements. You can then report all performance data for the defined period internally and/or to external stakeholders using these reports.
Before you can implement this principle, you need to have a clear understanding of 3 important types of financial statements:
- Profit and loss statements (a financial statement that summarizes the revenues, costs, and expenses that your business has incurred during a specified period)
- Balance sheets (a summary of the financial balances of an organization)
- Cash flow statements (a financial statement that consolidates all cash inflows received by an organization from its ongoing operations)
Dual aspect concept
The dual aspect concept is derived from the accounting equation which, as we saw above, is based on the formula Assets = Liabilities + Equity. It also forms an important basis of double entry accounting, required by all accounting frameworks, as it ensures the creation of reliable financial statements.
With this principle, you must record all business transactions in two different accounts (credit and debit). This is because all transactions impact the business in equally opposing ways (profit and loss). As a result, you must directly attribute your expenses to revenue. The aim is to report a clear association between what a company has paid out and what it has gained. This data is then included in a company’s balance sheet, where assets represent the sum of all equity and liabilities.
This is the only accounting concept accepted by external auditors if they need to inspect your financial statements.
Verifiable objective evidence concept
The final accounting concept that we are going to share is the verifiable objective evidence concept.
This principle states that you must not record or process financial transactions unless you can support them with objective documented evidence. Accepted evidence includes invoices, cash memos, or bank transfers. You also need to evidence larger transactions (land, property and vehicles) with title deeds or sales deeds.
If you cannot evidence your financial transactions, an auditor or tax inspector can claim that they are biased or undependable. As a result, your financial statements will not reflect the true financial status of your organization. A lack of verifiable objective evidence can also lead to claims of financial irregularities.
Accounting concepts conclusion
Now that we’ve seen what accounting concepts are and which principles you need to understand, let’s remind ourselves of why using at least one of these concepts is so important for building a profitable and compliant business.
For one thing, without clear standards for running your accounting process, it’s very difficult to understand the financial health of your business. Secondly, following a defined principle ensures you meet financial regulatory obligations. Plus, using a basic concept of accounting enables you to report your financial data to stakeholders and investors in a standardized format that is easy for them to understand. And this helps to secure long-term financial stability for your business.
However, although it’s essential that you understand these principles, it’s equally important that you have access to relevant financial data. This will help you effectively implement your chosen accounting concept. The best way to access this data is by using data analytics software.
For example, you can use Factorial’s financial workspace feature to digitalize your data collection processes. That way, you have easy access to important financial analytics, especially those relating to your overhead costs. For instance, you can automatically generate detailed employee cost and workforce analytics when you upload your payroll summaries. This helps you maintain control over your employee costs, including headcount analyses and projections. And with this level of visibility and control, you can easily identify opportunities to reduce costs and improve the overall financial health of your business moving forward.