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What is the prudence concept in accounting? 

Under the prudence concept , you should not overestimate the amount of revenues that yourecord, nor underestimate the expenses. You should also be conservative in recording theamount of assets, and not underestimate liabilities.

Another way of looking at prudence is to only record a revenue transaction or an asset whenit is certain, and to record an expense transaction or liability when it is probable. Anotheraspect of the prudence concept is that you would tend to delay recognition of a revenuetransaction or an asset until you are certain of it, whereas you would tend to record expensesand liabilities at once, as long as they are probable. In short, the tendency under the prudenceconcept is to either not recognize profits or to at least delay their recognition until theunderlying transactions are more certain.

he prudence concept does not !uite go so far as to force you to record the absolute leastfavorable position "perhaps that would be entitled the pessimism concept#$. Instead, what youare striving for is to record transactions that reflect a realistic assessment of the probability ofoccurrence. hus, if you were to create a continuum with optimism on one end and

 pessimism on the other, the prudence concept would place you somewhat further in thedirection of the pessimistic side of the continuum.

You would normally exercise prudence in setting up, for example, an allowance for doubtfulaccounts or a reserve for obsolete inventory. In both cases, a specific item that will cause anexpense has not yet been identified, but a prudent person would record a reserve inanticipation of a reasonable amount of these expenses arising.

%enerally Accepted Accounting &rinciples incorporates the prudence concept in many of itsstandards, which "for example$ re!uire you to write down fixed assets when their  fair values fall below their book values, but which do not allow you to write up fixed assets when thereverse occurs. International 'inancial (eporting )tandards do allow for the upwardrevaluation of fixed assets, and so do not adhere so rigorously to the prudence concept.

he prudence concept is only a general guideline. Ultimately, you must use your best *udgment in determining how and when to record an accounting transaction.

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What is a going concern qualification? 

he going concern principle is that you assume a business will continue in the future, unlessthere is evidence to the contrary.

+hen an auditor  conducts an examination of the accounting records of a company, he has anobligation to review its ability to continue as a going concern if his assessment is that there isa substantial doubt regarding the company-s ability to continue in the future "which is definedas the following year$, then he must include a going concern qualification in his opinion ofthe company-s financial statements. his statement is typically presented in a separateexplanatory paragraph that follows the auditor-s opinion paragraph.

here are no specific procedures that an auditor must follow to arrive at a going concernopinion. Instead, he derives this information from the sum total of all other audit procedures

 performed. Indicators of a potential going concern problem are

•  Negative trends. /an include declining sales, increasing costs, recurring losses,

adverse financial ratios, and so forth.

•  Employees. 0oss of key managers or skilled employees, as well as labor difficulties

of various types.

• Systems. Inade!uate accounting record keeping.

•  Legal . 0egal proceedings against the company, which may include pending liabilities

and penalties related to environmental or other laws.

•  Intellectual property. he loss of a key license or patent.

•  Business structure. he company has lost a ma*or customer  or key supplier .

•  Financing . he company has defaulted on a loan or is unable to locate new financing.

he auditor-s going concern !ualification can be mitigated by management if it has a plan tocounteract the problem. If such a plan exists, the auditor must assess its likelihood ofimplementation and obtain evidential matter about the most significant elements of the plan.

'or example, if the /12 has declared that he will extend a loan to the company to cover a pro*ected cash shortfall, evidential matter might be considered a promissory note in which the/12 is obligated to provide a stated amount of funds to the company.

he going concern !ualification is of great concern to lenders, since it is a ma*or indicator ofthe inability of a company to pay back its debts. )ome lenders specify in their loandocuments that a going concern !ualification will trigger the acceleration of all remainingloan payments. A lender is typically only interested in lending to a business that has receivedan un!ualified opinion from its auditors regarding its financial statements.

An auditor who is considering issuing a going concern !ualification will discuss the issuewith management in advance, so that management can create a recovery plan that may be

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sufficient to keep the auditor from issuing the !ualification. hus, the going concern!ualification is a ma*or issue, but you will have a chance to find a way around the problemand potentially keep the auditor from issuing it.

What is the accrual concept in accounting? 

Accrual concept

his concept is also known as the accrual theory of accounting or accrual accounting. his

concept applies e!ually to revenues and expenses. In the accrual basis of accounting (evenue

is recognized when it is realized, that is, when the sale is complete or not.

)imilarly, the expenses are recognized in the accounting period in which they assist in

earning the (evenues, whether the cash has been paid for them or not. (ecognition of

revenues and expenses for the income determination, therefore, does not depend upon the

time when the cash is actually received for expenses or paid for expenses.

he essence of revenue is that a mere promise on the part of a customer to pay the money for

the sale or service or Interest, /ommission, (ent etc. in future is considered as (evenue.

)imilarly, a promise on the part of the business entity to make payment for salaries, rent etc.

ion future is considered as an 1xpense. Income "excess of (evenue or 1xpenses$ is associated

with the change in the owners3 e!uity and that is not necessarily related to changes in cash.

Example: A business entity may sell goods for 456666 on 7ecember 58, 5669 and the

 payment is not received until :anuary 58, 5668. he sale of goods would result in an increase

in the assets "debtors$ of the firm of 456666 and increase in the capital by the same amount

"of course to be reduced by the cost of the goods sold$ although no cash has been received.

;owever, when the /ash is received on :anuary 58, 5668, this would not result in (evenue. It

would result in increase in one asset "cash$ and a decrease in another asset "debtors$.

)imilarly expenses and cash payments are not the same because a distinction is made

 between /apital and (evenue 1xpenditures.

2ther 1xamples of /ash &ayments which are not expenses include purchase of a machine for

cash "an increase in one asset < machine and a decrease in the other asset < cash$, the payment

of creditors and so on.

hus, we can say that the accrual concept makes the distinction between the receipts of cash

and the right to receive the cash and the payment of cash and legal obligations to receive

cash, because in practice there is usually no coincide=nce in time between cash movements

and legal obligations which they relate.

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he *ustification for the accrual concept is that earning of revenue and consumption of a

resource "expenses$ can be accurately related to particular or specific accounting period. his

would enable the measurement of Income of matching expenses and revenue. he drawbacks

include<

i. he apportion of expenses to different time periods is a time consuming process and

ii. 'inancial statements become more complex for the layman who may find it difficult to

understand the difference between the actual receipt of cash and the right to receive the cash

and also the actual payments and the obligation to pay.In other words the inclusion of

 prepayments and inclusions in the >alance )heet may not be understood easily

What is materiality concept in accounting? 

Information is material if its omission or misstatement could influence the economicdecisions of users taken on the basis of the financial statements "IA)> 'ramework$.

?ateriality therefore relates to the significance of transactions, balances and errors containedin the financial statements. ?ateriality defines the threshold or cutoff point after whichfinancial information becomes relevant to the decision making needs of the users.Information contained in the financial statements must therefore be complete in all materialrespects in order for them to present a true and fair view of the affairs of the entity.

?ateriality is relative to the size and particular circumstances of individual companies.

Example - Size

A default by a customer who owes only 4@666 to a company having net assets of worth 4@6million is immaterial to the financial statements of the company.

;owever, if the amount of default was, say, 45 million, the information would have beenmaterial to the financial statements omission of which could cause users to make incorrect

 business decisions.

Example - NatureIf a company is planning to curtail its operations in a geographic segment which hastraditionally been a ma*or source of revenue for the company in the past, then thisinformation should be disclosed in the financial statements as it is by its nature material tounderstanding the entity-s scope of operations in the future.

?ateriality is also linked closely to other accounting concepts and principles

• (elevance ?aterial information influences the economic decisions of the users and is

therefore relevant to their needs.

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• (eliability 2mission or mistatement of an important piece of information impairs

users- ability to make correct decisions taken on the basis of financial statementsthereby affecting the reliability of information.

• /ompleteness Information contained in the financial statements must be complete in

all material respects in order to present a true and fair view of the affairs of thecompany.

The Accrual rinciple

he accrual principle is the concept that you should record accounting transactions in the period in which they actually occur, rather than the period in which the cash flows related tothem occur. he accrual principle is a fundamental re!uirement of all accounting frameworks,such as %enerally Accepted Accounting &rinciples and International 'inancial (eporting)tandards.

1xamples of the proper usage of the accrual principle are

• (ecord sales when you invoice the customer , rather than when the customer pays you.

• (ecord an expense when you incur it, rather than when you pay for it.

• (ecord the estimated amount of bad debt when you invoice a customer, rather than

when it becomes apparent that the customer will not pay you.

• (ecord depreciation for a fixed asset over its useful life, rather than charging it to

expense in the period purchased.

• (ecord a commission in the period when the salesperson earns it, rather than the

 period in which he is paid it.

• (ecord wages in the period earned, rather than in the period paid.

+hen properly implemented, the accrual principle allows you to aggregate all revenue andexpense information for an accounting period, without the distortions and delays caused bythe cash flows arising from that accounting period.

(ecording transactions under the accrual principle may re!uire the use of an accrual  *ournalentry. An example of such an entry for a sale on credit is

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  7ebit /redit

Accounts receivable ,666

)ales ,666

 In this entry, revenue is recorded before payment from the customer arrives, along with anaccounts receivable asset in the same amount. In the following month, the customer pays thecompany, and the company records the following entry

  7ebit /redit

/ash ,666

Accounts (eceivable ,666

he cash balance increases as a result of the customer payment, which also eliminates theaccounts receivable asset. If you do not use the accrual principle, then you are using the cashmethod of accounting, where you record revenue when cash is received and expenses whenthey are paid. here are also modified versions of the cash method of accounting that allowfor the limited use of accruals.

The !onser"atism rinciple

he conservatism principle is the general concept of recognizing expenses and liabilities assoon as possible when there is uncertainty about the outcome, but to only recognize revenues and assets when they are assured of being received. hus, when given a choice betweenseveral outcomes where the probabilities of occurrence are e!ually likely, you shouldrecognize that transaction resulting in the lower amount of   profit, or at least the deferral of a

 profit. )imilarly, if a choice of outcomes with similar probabilities of occurrence will impactthe value of an asset, recognize the transaction resulting in a lower recorded asset valuation.

Under the conservatism principle, if there is uncertainty about incurring a loss, you shouldtend toward recording the loss. /onversely, if there is uncertainty about recording a gain, youshould not record the gain.

he conservatism principle can also be applied to recognizing estimates. 'or example, if thecollections staff believes that a cluster of receivables will have a 5B bad debt  percentage

 because of historical trend lines, but the sales staff is leaning towards a higher 8B figure because of a sudden drop in industry sales, then use the 8B figure when creating anallowance for doubtful accounts, unless there is strong evidence to the contrary.

he conservatism principle is the foundation for the lower of cost or market rule, which statesthat you should record inventory at the lower of either its ac!uisition cost or its currentmarket value.

he conservatism principle is only a guideline. As an accountant, you should use your best *udgment to evaluate a situation and to record a transaction in relation to the information you

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have at that time. You should not use the principle to consistently record the lowest possibleearnings for a company.

The !onsistency rinciple

he consistency principle states that, once you adopt an accounting principle or method, youshould continue to follow it consistently in future accounting periods. You should onlychange an accounting principle or method if the new version in some way improves reportedfinancial results. if you make such a change, you should fully document its effects, andinclude this documentation in the notes accompanying the financial statements.

Auditors are especially concerned that their clients follow the consistency principle, so thatthe results reported from period to period are comparable. An auditor may refuse to provide

an opinion on a client-s financial statements if there are clear and unwarranted violations ofthe principle.

he consistency principle is most fre!uently ignored when the managers of a business aretrying to report more revenue or profits than would be allowed through a strict interpretationof the accounting standards. A telling indicator of such a situation is when the underlyingcompany operational activity levels do not change, but profits suddenly increase.

The !ost rinciple

he cost principle is the general concept that you should only record an asset, liability, ore!uity investment at its original ac!uisition cost. he principle is widely used to recordtransactions, partially because it is easiest to use the original purchase price as an ob*ectiveand verifiable evidence of value.

A variation on the concept is to allow the recorded cost of an asset to be lower than itsoriginal cost, if the market value of the asset is lower than the original cost. ;owever, thisvariation does not allow the reverse < to revalue an asset upward. hus, this is a crushinglyconservative view of the cost principle.

he obvious problem with the cost principle is that the historical cost of an asset, liability, ore!uity investment is simply what it was worth on the ac!uisition date it may have changedsignificantly since that time. In fact, if a company were to sell its assets, the sale price might

 bear little relationship to the amounts recorded on its balance sheet. hus, the cost principleyields results that may no longer be relevant, and so of all the accounting principles, it has

 been the most seriously in !uestion.

he cost principle is not applicable to financial investments, where accountants are re!uiredto record them at their fair values at the end of each reporting period.

Using the cost principle for short<term assets and liabilities is the most *ustifiable, since an

entity will not have possession of them long enough for their values to change markedly.

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he cost principle is less applicable to long<term assets and liabilities. hough depreciation,amortization, and impairment charges are used to bring them into approximate alignmentwith their fair values over time, the cost principle leaves little room to revalue these itemsupward. If a balance sheet is heavily weighted towards long<term assets, as is the case in acapital<intensive industry, then there is a greater risk that the balance sheet will not accurately

reflect the actual values of the assets recorded on it.

he cost principle implies that you should not revalue an asset, even if its value has clearlyappreciated over time. his is not entirely the case under %enerally Accepted Accounting&rinciples, which allows some ad*ustments to fair value. he cost principle is even lessapplicable under International 'inancial (eporting )tandards, which not only permitsrevaluation to fair value, but also allows you to reverse an impairment charge if an assetsubse!uently appreciates in value.

The #e"enue #ecognition rinciple

he revenue recognition principle states that, under the accrual basis of accounting, youshould only record revenue when an entity has substantially completed a revenue generation

 process thus, you record revenue when it has been earned. 'or example, a snow plowingservice completes the plowing of a company-s parking lot for its standard fee of 4@66. It canrecognize the revenue immediately upon completion of the plowing, even if it does notexpect payment from the customer  for several weeks.

Also under the accrual basis of accounting, if an entity receives payment in advance from acustomer, then the entity records this payment as a liability, not as revenue. 2nly after it hascompleted all work under the arrangement with the customer can it recognize the payment as

revenue.

Under the cash basis of accounting, you should record revenue when a cash payment has been received. 'or example, using the same scenario as *ust noted, the snow plowing servicewill not recognize revenue until it has received payment from its customer, even though thismay be a number of weeks after the plowing service completed all work.

The Economic Entity rinciple

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he economic entity principle states that the activities of a business entity will be keptseparate from the activities of its owner"s$ and any other business entities. his means thatyou must maintain separate accounting records for each entity, and not intermix with themthe assets and liabilities of its owners or business partners. Also, you must associate every

 business transaction with an entity.

A business entity can take a variety of forms, such as a sole proprietorship, partnership,corporation, or government agency.

It is customary to consider a commonly<owned group of business entities to be a single entityfor the purposes of creating consolidated financial statements for the group.

he economic entity principle is a particular concern when businesses are *ust being started,for that is when the owners are most likely to commingle their funds with those of the

 business. A typical outcome is that an accountant must be brought in after a business beginsto grow, in order to sort through earlier transactions and remove those that should be more

appropriately linked to the owners.

The $oing !oncern rinciple

he going concern principle is the assumption that an entity will remain in business for theforeseeable future. /onversely, this means the entity will not  be forced to halt operations andli!uidate its assets in the near term. >y making this assumption, the accountant is *ustified indeferring the recognition of some expenses until a later period, when the entity will

 presumably still be in business and using its assets.

An entity is assumed to be a going concern in the absence of significant information to thecontrary. An example of such contrary information is an entity3s inability to meet itsobligations as they come due without substantial asset sales or debt restructurings. If suchwere not the case, an entity would essentially be ac!uiring assets with the intention of closingits operations and reselling the assets to another party.

If the accountant believes that an entity may no longer be a going concern, then this brings upthe issue of whether its assets are impaired, which may call for the write<down of theircarrying amount to their li!uidation value. hus, the value of an entity that is assumed to be agoing concern is higher than its breakup value, since a going concern can potentially continueto earn profits.

he going concern concept is not clearly defined anywhere in generally accepted accounting principles, and so is sub*ect to a considerable amount of interpretation regarding when an

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entity should report it. ;owever, generally accepted auditing standards "%AA)$ do instructan auditor  regarding the consideration of an entity3s ability to continue as a going concern.

he auditor evaluates an entity3s ability to continue as a going concern for a period notgreater than one year following the date of the financial statements being audited. he auditor 

considers such items as negative trends in operating results, loan defaults, denial of tradecredit from suppliers, uneconomical long<term commitments, and legal proceedings indeciding if there is a substantial doubt about an entity3s ability to continue as a going concern.If so, the auditor must !ualify the audit report with a statement about the problem.

The %onetary &nit rinciple

he monetary unit principle states that you only record transactions that can be expressed in

terms of currency. hus, you cannot record such non<!uantifiable items as employee skilllevels or the !uality of customer service.

he monetary unit principle also assumes that the value of the unit of currency in which yourecord transactions remains stable over time. ;owever, given the amount of persistentcurrency inflation in most economies, this assumption is not correct < for example, a dollarinvested to buy an asset 56 years ago is worth considerably more than a dollar invested today,

 because the purchasing power of the dollar has declined during the intervening years. heassumption fails completely if an entity records transactions in the currency of ahyperinflationary economy.

The %ateriality rinciple

he materiality principle is the magnitude of an omission or misstatement in an entity-sfinancial statements that makes it probable that a reasonable person relying on those financialstatements would have been influenced by the omitted information or made a different

 *udgment if the correct information had been known. Under generally accepted accounting principles "%AA&$, you do not have to implement the provisions of an accounting standard if

an item is immaterial. his definition does not provide definitive guidance in distinguishingmaterial information from immaterial information, so you must exercise *udgment in decidingif a transaction is material.

he )ecurities and 1xchange /ommission has suggested for presentation purposes that anitem representing at least 8B of total assets should be separately disclosed in the balancesheet. ;owever, much smaller items may be considered material. 'or example, if a minoritem would have changed a net profit to a net loss, that item could be considered material, nomatter how small it might be. )imilarly, a transaction would be considered material if itsinclusion in the financial statements would change a ratio sufficiently to bring an entity out of compliance with its lender covenants.

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As an example of a clearly immaterial item, you may have prepaid 4@66 of rent on a postoffice box that covers the next six months under the matching principle, you should chargethe rent to expense over six months. ;owever, the amount of the expense is so small that noreader of the financial statements will be misled if you charge the entire 4@66 to expense inthe current period, rather than spreading it over the usage period.

he materiality concept varies based on the size of the entity. A massive multi<nationalcompany may consider a 4@ million transaction to be immaterial in proportion to its totalactivity, but 4@ million could exceed the revenues of a small local firm, and so would be verymaterial for that smaller company.

he materiality principle is especially important when deciding whether a transaction should be recorded as part of the closing process, since eliminating some transactions cansignificantly reduce the amount of time re!uired to issue financial statements.

The %atching rinciple

he matching principle is one of the cornerstones of the accrual basis of accounting. Underthe matching principle, when you record revenue, you should also record at the same timeany expenses directly related to the revenue. hus, if there is a cause<and<effect relationship

 between revenue and the expenses, record them in the same accounting period.

;ere are several examples of the matching principle

• Commission. A salesman earns a 8B commission on sales shipped and recorded in

:anuary. he commission of 48,666 is paid in 'ebruary. You should record thecommission expense in :anuary.

•  Depreciation. A company ac!uires production e!uipment for 4@66,666 that has a

 pro*ected useful life of @6 years. It should charge the cost of the e!uipment todepreciation expense at the rate of 4@6,666 per year for ten years.

•  Employee bonuses. Under a bonus plan, an employee earns a 486,666 bonus based on

measurable aspects of her performance within a year. he bonus is paid in the

following year. You should record the bonus expense within the year when theemployee earned it.

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• ages. he pay period for hourly employees ends on ?arch 5, but employees

continue to earn wages through ?arch =@, which are paid to them on April 9. heemployer should record an expense in ?arch for those wages earned from ?arch 5Cto ?arch =@.

(ecording items under the matching principle typically re!uires the use of an accrual entry.An example of such an entry for a commission payment is

  7ebit /redit

/ommission expense 8,666

Accrued expenses 8,666

 In this entry, the commission expense is charged before the cash payment actually occurs,

along with a liability in the same amount. In the following month, the company pays thecommission, and records the following entry

  7ebit /redit

Accrued expenses 8,666

/ash 8,666

he cash balance declines as a result of paying the commission, which also eliminates the

liability.

 If you do not use the matching principle, then you are using the cash method of accounting, where you record revenue when cash is received and expenses when they are paid.

The Time eriod rinciple

he time period principle is the concept that a business should report the financial results ofits activities over a standard time period, which usually monthly, !uarterly, or annually. 2nce

the duration of each reporting period is established, you use the guidelines of  %enerallyAccepted Accounting &rinciples or  International 'inancial (eporting )tandards to recordtransactions within each period.

You must include in the header of any financial statement the time period covered by thestatement. 'or example, an income statement may cover the D1ight ?onths ended August=@.D

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The #elia'ility rinciple

he reliability principle is the concept of only recording those transactions in the accounting

system that you can verify with ob*ective evidence. 1xamples of ob*ective evidence are

• &urchase receipts

• /ancelled checks

• >ank statements

• &romissory notes

• Appraisal reports

 Eote that the examples shown here are of documents generated by other entities "customers,suppliers, valuation experts, and banks$. )ince they are third parties, documents supplied bythem are considered to be of higher value as ob*ective evidence than documents createdinternally.

he reliability principle is particularly difficult to meet when you are recording a reserve,such as an inventory obsolescence reserve or an allowance for doubtful accounts, since thesereserves are essentially opinion<based. In these cases, it is particularly important to *ustifyyour actions with a detailed analysis of the reasons for the reserve. his is fre!uently basedon verifiable historical experience with similar transactions, and which you expect to berepeated in the future.

'rom a practical perspective, you should only record those transactions that an auditor couldreasonably be expected to verify through normal audit procedures.