11 Important Accounting Concepts And What They Mean

Updated 20 February 2023

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Accounting concepts are ideas, assumptions and conditions based on which a business entity records its financial transactions and organises its bookkeeping. It helps a business interpret and integrate a financial transaction into the accounting process. It is important for a business owners and accountants to understand basic concepts to bring about consistency and uniformity in their accounting process. In this article, we examine accounting concepts and discuss the difference between concepts and conventions, along with the meaning of a few concepts.

What are accounting concepts?

Accounting concepts are theoretical ideas, components and terms that make up the subjects accounting, finance and economics. These terms help individuals, businesses or organisations systematically record their financial information and transactions. Accountants use these concepts as guidelines to prepare financial reports and other documents for individuals and businesses. Companies tend to follow accounting standards, principles and accounting laws of the countries they operate in. These principles include concepts and conventions that help those companies report transactions accurately.

Concepts and principles are critical parts of accounting because they set up a universal framework for discussing particular financial situations, rules and theories. The concepts are crucial, as they can help clarify the details of complex transactions and assist in resolving any disputes that may arise while creating financial statements. You could think of these concepts as ‘what accountants do' and accounting principles as ‘how they do it.'

Why are concepts necessary in accounting?

Accountants are professionals who record the financial transactions of a company. Periodic summaries of these transactions or financial reports give managers, investors, analysts and the government relevant financial information about a company. If every business follows an independent system for creating and producing summaries and statements, it could lead to discrepancies and increase the scope of fraud and financial mismanagement. To overcome this, accounting bodies, governments and regulatory agencies use a universally agreed-upon set of principles to standardise accounting practises.

What is the difference between a concept and convention?

Concepts and conventions together make up accounting principles. Accounting concepts are rules and guidelines that a company follows to manage accounts that record financial transactions. Government bodies and financial institutions legally recognise these concepts, and a legal and regulatory framework complements their function. One of the primary benefits of these concepts is that they aid in recording financial transactions based on evidence and leave little to no chance for personal or professional bias or gain. Accounting concepts aid in creating standards, resolving potential disputes and preventing fraud and irregularities.

Accounting conventions are a set of practises that a business entity follows over a period of time to prepare its accounts. Unlike theoretical concepts, conventions are a procedure that companies universally follow. The purpose of accounting conventions is to guide accountants while they prepare financial statements. Accounting conventions are dynamic and can change when new concepts and principles emerge. One major advantage of following accounting conventions is that it ensures similar accounting practises across businesses, making it easy for stakeholders to interpret the financial performance of different companies using the same benchmark.

11 important concepts in accounting

Accounting bodies classify concepts as based on assumptions or based on principles. Every type of business—including a sole proprietorship, partnership or a public or private company—records its financial transactions based on these assumptions and principles. These are some of the important concepts in accounting:

1. Business entity concept

The business entity, economic entity or separate entity concept assumes that a business is independent of its owner. A business may not record its owner's personal expenses, income, liabilities and assets. It aids in tracking a business's expenses, incomes and tax deductions without any ambiguity. In addition, it safeguards a business owner's personal finances and helps build their creditworthiness. It reflects cash flow and financial position more accurately. This clear distinction helps stakeholders and creditors take appropriate business decisions based on a company's performance rather than the owner's financial position.

2. Going concern concept

Going concern concept prescribes that accountants prepare financial statements on the assumption that a business may continue its operations for the foreseeable future. Under this concept, the definition of a foreseeable future is a period of 12 months from the end date of the reporting period. If a business owner or the management is invested in scaling down business operations to zero, they cannot apply the going concern concept for accounting. Accountants may no longer apply the going concern concept if a company is:

unable to pay dividends
unable to raise credit from banks and financial services
facing losses and negative operating cash flow
facing an adverse financial position
unable to pay back crucial debts
facing an unfavourable legal or regulatory action against it

3. Money measurement concept

This is an accounting concept based on assumption, and it stipulates that companies record only those transactions that they can quantify and measure in terms of money. If they cannot assign a monetary value to a transaction, they do not record it in their annual financial statement. Though these transactions affect a company's financial performance, they may not find a place in financial statements, as monetising them can be challenging. Some examples of non-monetary value include employee competence, product quality, employee efficiency, market sentiment, business productivity and stakeholder satisfaction.

4. Accounting period concept

The accounting period concept prescribes a timeframe within which a business records and reports its financial performance for the purview of internal and external stakeholders. An accounting period of a company may coincide with the fiscal year. A company can determine a timeframe for internal reporting, like three or six months, or prepare monthly financial reports to analyse their cash flow positions. The management can determine a convenient accounting period for internal reporting, but the reporting for investor, government and tax purposes is typically for the period of one year.

5. Accrual concept

Accrual is a fundamental concept that guides how a business can record cash or credit transactions. Under this concept, a business records a financial transaction in the period it occurs. It does not consider whether the business pays or receives cash at the time of the transaction, or if it pays cash after a certain period. For example, a company records a credit purchase at the time of purchase rather than when it pays back the seller. This helps record and report income, expenses, liabilities and receivables accurately. All modern accounting systems follow the accrual concept in recording financial transactions.

6. Revenue realisation concept

Under the revenue realisation or revenue recognition concept, a seller records potential revenue from a transaction, regardless of whether they have or have not received proceeds. The ownership of a product transfers from a buyer to a seller during a sale. A seller recognises the transaction by creating a receivable against the buyer's name in their ledger. An accountant creates another entry when they receive the due amount in the future.

7. Full disclosure concept

The full disclosure concept requires a business entity to furnish necessary information for the benefit of those who read financial statements and reports for investment, taxation or audit purposes. This concept aims to provide important financial information to investors, creditors, shareholders, clients, and other stakeholders. Disclosure policies cover revenue recognition, depreciation, inventory, taxes, earnings, stock value, leases and liabilities.

8. Dual aspect concept

Dual aspect concept states that every transaction affects two accounts of a business. A business then records both aspects to enable accurate accounting. Every financial transaction has a credit or debit or a giver or receiver aspect. If an accounting process does not represent both, it may lead to faults in the final accounting record. The dual aspect concept is the foundation of the double-entry system of bookkeeping, which is now a standard method for auditing and taxation.

9. Materiality concept

The materiality concept prescribes guidelines to identify if a piece of financial information is material and whether it can influence the person reading a company's financial statements. Based on this concept, an accountant or a business may remove negligible transactions that may not have a bearing on final accounts. This concept is open to subjective interpretation and the basis for using the materiality concept varies with the size of a company. While a large company may round off figures in the final accounts to crores, a small firm may round off their figures to lakhs.

10. Verifiable objective evidence concept

Under this concept, a business can record only those transactions that they can furnish documentary proof for. Without proper and valid documentary evidence, a transaction can be biased or undependable, and it can increase the scope of financial irregularities. For example, a retail employee may present a bill for purchases and sales, and corroborate it with sale and purchase invoices.

11. Historical cost concept

The historical cost concept states that a business may record assets and liabilities at their historical cost rather than their current market or sale value. It helps to maintain consistent, reliable and verifiable financial information. Including the current value of an entity can result in financial irregularities.