Fundamental Financial Accounting Concepts

The four main concepts that underlie financial statements are:

  1. Accounting entities and reporting entities
  2. The accounting equation
  3. Accrual accounting
  4. Profit

Over the past two decades the accounting profession has developed an internationally agreed description of the concepts in financial reporting.

An accounting entity is anyy organisation or unit, regardless of its type of structure. An accounting entity is seperate from the owner, therefore the entity is responsible for any liabilities incurred, not the owner. Therefore monetary transactions are kept separate. The accounting entity concept has given rise to the accounting equation. Journal entries can be expressed in double-entry according to the equation:

Assets = Liabilities + Equity

Business activity is divided into artificial segments of time known as accounting periods. Income can be subdivided into two categories: revenue, which is defined as inflows or enhancements that arise from the organisation's ordinary activities such as the provision of standard goods or services; and gains, which are defined as any other inflows or enhancements. In the process of earning income, organisations generally use goods or services of some kind and incur associated costs. For each source of income, accountants are therefore required to identify the specific associated costs and record these as expenses.

Not all costs are incurred during the same accounting period as the associated income. The accrual accounting method was developed to address this issue and is mandatory under current accounting standards. It specifies that wherever a cost can be directly related to a specific line of income it must be recorded as an expense during the same accounting period as that income, regardless of the actual timing of the cost outlay. It also means that revenue and expenses as shown under the accrual method may not, and in the majority of cases do not, directly relate to the flow of cash into or out of an organisation. Where the relationship between costs and income is less direct, accountants tend to record the costs as expenses in the period in which they are incurred.

Historically, public sector accounting has been identified with fund accounting. A fund generally means a set of resources that are allocated to achieve some specified goal. Fund accounting is essentially a cash-based system and gives no recognition to the period convention of accrual accounting. Fund accounting does not provide details of investments in property, equipment or other assets and does not report liabilities or any obligations owed.

Profit is the difference between the wealth at the start of a defined period and the wealth at the end of that period. It is calculated using the following equation:

Profit = Income – Expenses

Profit leads to an overall (net) increase in the assets held by an organisation. Therefore, we view net profit as being the net increases in earned resources of the organisation. Any profit gained from trading operations will increase owner's equity, and if a loss occurs due to expenses exceeding income, a decrease in owner's equity will result.

A transaction is an exchange of items of value between two or more parties that changes the financial position and/or earnings of each. Transactions are communicated to accountants via source documents such as sales invoices or payment receipts. Source documents are critical to the accounting process because they provide evidence that a transaction has taken place.

Inventories, also sometimes referred to as stocks, can be divided into four categories:

  • raw materials that are purchased for use in the manufacture or production of goods to be sold
  • consumable goods such as parts and supplies that are purchased for use in the manufacture or production of goods to be sold
  • work in progress, which includes goods that are currently being manufactured
  • items available for sale to customers

As inventories will generally be sold within the normal operating cycle of business, they are classified as current assets. A range of different methods can be used to value inventories and calculate the cost of goods sold.

  • the first in, first out (FIFO) method
  • the last in, first out (LIFO) method
  • the weighted average cost method.