The following four fundamental accounting concepts are broad basic assumptions that underlie the preparation of financial statements of businesses. In addition, they have such general acceptance as established accounting practice that their observance is presumed, unless otherwise stated in the financial statements, although a knowledge and understanding of them is assumed.
The four concepts are listed in statement AC 101 entitled “The Disclosure of Accounting Policies” issued by the South African Institute of Chartered Accountants.
1. The ‘going concern’ concept
The business entity will continue in operational existence for the foreseeable future. This means in particular that the income statement and balance sheet assume no intention or necessity to liquidate, or curtail significantly, the scale of operation.
Although the ‘going concern’ concept does not always apply, in the sense that all business entities can come to an end, the assumption of the continuity of a business entity is so essential to the determination of periodic income, that its selection as a basic assumption was inevitable. It gives users of financial statements assurance, by requiring disclosure when a business entity is not a going concern. One has only to think of the implications if this was not the case, or if a liquidating concept was used, to realise why the ‘going concern’ is a fundamental concept.
2. The ‘matching’ concept
Revenue and costs are accrued (that is, recognised as they are earned or incurred not as they money is received or paid), matching one with another so far as their relationship can be established or justifiably assumed, and dealt with in the income statement for the period for which they relate. The only provision is that where the matching concept is inconsistent with the prudence concept (see below) the latter prevails. Revenue and profits dealt with in the income statement are matched with the associated costs and expenses by including in the same account, the costs incurred in earning them (so far as these are material and identifiable).
Although revenue and costs and expenses do not occur simultaneously, they are recognised as they are earned or incurred in the financial statements of the period to which they relate. It is a generally accepted basic assumption that revenue and expenses must be matched in order to give the users of financial statements a correct presentation of periodic income. In addition, the disclosure of any departure from this concept gives the user protection with regard to the validity of periodic income figures. Thus, ‘matching’ is a fundamental accounting concept.
3. The ‘consistency’ concept
There is consistency of accounting treatment of like items within each accounting period and from one accounting period to the next.
The importance of this concept lies in the requirement of disclosure of inconsistency in the treatment of like items in successive accounting periods. Without it the comparison of periodic income of the business would be meaningless. The consistency concept gives the users of financial statements some assurance that the reported income is reliable. They are thus able to determine whether or not changes in reported income from one period to the next are the result of actual business operations and transactions. It is, therefore, an essential assumption in accounting practice, that accounting methods or policies are employed consistently in a business, and that any changes in such methods or policies will be disclosed.
4. The ‘prudence’ concept
Revenue and profits are not anticipated, but are recognised by inclusion in the income statement only when realised in the form of cash or other assets, the ultimate realisation of which can be assessed with reasonable certainty. Provision is made for all known liabilities (expenses and losses) whether the amount of these is known with certainty or is an estimate in the light of the information available.
Pessimism is generally accepted to be preferable to optimism in financial statements. This stems from the fact that in the development of accounting practice, it is more desirable to develop logic from a pessimistic point of view than from an optimistic one.
A business does not account for its profits unless they are realised. On the other hand, it is usual to take account of losses immediately.
An important example of the accounting for potential losses is a provision for any accounts receivable (debtors) that might not be recovered. If the debtors account is overdue and will probably not be paid, the asset is not shown in the balance sheet but is written off as an expense instead.
Source: Business Accounting & Finance by Bradshaw & Brooks - Juta