What is the prudence concept in accounting?

Under the prudence concept, you should not overestimate the amount of revenues that you
record, nor underestimate the expenses. You should also be conservative in recording the
amount of assets, and not underestimate liabilities.
Another way of looking at prudence is to only record a revenue transaction or an asset when
it is certain, and to record an expense transaction or liability when it is probable. Another
aspect of the prudence concept is that you would tend to delay recognition of a revenue
transaction or an asset until you are certain of it, whereas you would tend to record expenses
and liabilities at once, as long as they are probable. In short, the tendency under the prudence
concept is to either not recognize profits or to at least delay their recognition until the
underlying transactions are more certain.
The prudence concept does not quite go so far as to force you to record the absolute least
favorable position (perhaps that would be entitled the pessimism concept!). Instead, what you
are striving for is to record transactions that reflect a realistic assessment of the probability of
occurrence. Thus, 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 the
direction of the pessimistic side of the continuum.
You would normally exercise prudence in setting up, for example, an allowance for doubtful
accounts or a reserve for obsolete inventory. In both cases, a specific item that will cause an
expense has not yet been identified, but a prudent person would record a reserve in
anticipation of a reasonable amount of these expenses arising.
Generally Accepted Accounting Principles incorporates the prudence concept in many of its
standards, which (for example) require 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 the
reverse occurs. International Financial Reporting Standards do allow for the upward
revaluation of fixed assets, and so do not adhere so rigorously to the prudence concept.
The prudence concept is only a general guideline. Ultimately, you must use your best
judgment in determining how and when to record an accounting transaction.

What is a going concern qualification?

The going concern principle is that you assume a business will continue in the future, unless
there is evidence to the contrary.
When an auditor conducts an examination of the accounting records of a company, he has an
obligation to review its ability to continue as a going concern; if his assessment is that there is
a substantial doubt regarding the company's ability to continue in the future (which is defined
as the following year), then he must include a going concern qualification in his opinion of
the company's financial statements. This statement is typically presented in a separate
explanatory paragraph that follows the auditor's opinion paragraph.
There are no specific procedures that an auditor must follow to arrive at a going concern
opinion. 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. Can include declining sales, increasing costs, recurring losses,
adverse financial ratios, and so forth.

Employees. Loss of key managers or skilled employees, as well as labor difficulties

of various types.

Systems. Inadequate accounting record keeping.

Legal. Legal proceedings against the company, which may include pending liabilities
and penalties related to environmental or other laws.

Intellectual property. The loss of a key license or patent.

Business structure. The company has lost a major customer or key supplier.

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

The auditor's going concern qualification can be mitigated by management if it has a plan to
counteract the problem. If such a plan exists, the auditor must assess its likelihood of
implementation and obtain evidential matter about the most significant elements of the plan.
For example, if the CEO has declared that he will extend a loan to the company to cover a
projected cash shortfall, evidential matter might be considered a promissory note in which the
CEO is obligated to provide a stated amount of funds to the company.
The going concern qualification is of great concern to lenders, since it is a major indicator of
the inability of a company to pay back its debts. Some lenders specify in their loan
documents that a going concern qualification will trigger the acceleration of all remaining
loan payments. A lender is typically only interested in lending to a business that has received
an unqualified opinion from its auditors regarding its financial statements.
An auditor who is considering issuing a going concern qualification will discuss the issue
with management in advance, so that management can create a recovery plan that may be

sufficient to keep the auditor from issuing the qualification. Thus, the going concern
qualification is a major issue, but you will have a chance to find a way around the problem
and potentially keep the auditor from issuing it.

What is the accrual concept in accounting?

Accrual concept
This concept is also known as the accrual theory of accounting or accrual accounting. This
concept applies equally to revenues and expenses. In the accrual basis of accounting Revenue
is recognized when it is realized, that is, when the sale is complete or not.
Similarly, the expenses are recognized in the accounting period in which they assist in
earning the Revenues, whether the cash has been paid for them or not. Recognition 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.
The 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, Commission, Rent etc. in future is considered as Revenue.
Similarly, a promise on the part of the business entity to make payment for salaries, rent etc.
ion future is considered as an Expense. Income (excess of Revenue or Expenses) is associated
with the change in the owners equity and that is not necessarily related to changes in cash.
Example: A business entity may sell goods for $20000 on December 25, 2004 and the
payment is not received until January 25, 2005. The sale of goods would result in an increase
in the assets (debtors) of the firm of $20000 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.
However, when the Cash is received on January 25, 2005, this would not result in Revenue. It
would result in increase in one asset (cash) and a decrease in another asset (debtors).
Similarly expenses and cash payments are not the same because a distinction is made
between Capital and Revenue Expenditures.
Other Examples of Cash Payments 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.
Thus, 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 coincide3nce in time between cash movements
and legal obligations which they relate.

The justification 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. This
would enable the measurement of Income of matching expenses and revenue. The drawbacks
include:i. The apportion of expenses to different time periods is a time consuming process and
ii. Financial 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 Balance Sheet may not be understood easily

What is materiality concept in accounting?

Information is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of the financial statements (IASB Framework).
Materiality therefore relates to the significance of transactions, balances and errors contained
in the financial statements. Materiality defines the threshold or cutoff point after which
financial information becomes relevant to the decision making needs of the users.
Information contained in the financial statements must therefore be complete in all material
respects in order for them to present a true and fair view of the affairs of the entity.
Materiality is relative to the size and particular circumstances of individual companies.

Example - Size
A default by a customer who owes only $1000 to a company having net assets of worth $10
million is immaterial to the financial statements of the company.
However, if the amount of default was, say, $2 million, the information would have been
material to the financial statements omission of which could cause users to make incorrect
business decisions.

Example - Nature
If a company is planning to curtail its operations in a geographic segment which has
traditionally been a major source of revenue for the company in the past, then this
information should be disclosed in the financial statements as it is by its nature material to
understanding the entity's scope of operations in the future.
Materiality is also linked closely to other accounting concepts and principles:

Relevance: Material information influences the economic decisions of the users and is
therefore relevant to their needs.

Reliability: Omission or mistatement of an important piece of information impairs

users' ability to make correct decisions taken on the basis of financial statements
thereby affecting the reliability of information.

Completeness: 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 the
company.

The Accrual Principle

The 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 to
them occur. The accrual principle is a fundamental requirement of all accounting frameworks,
such as Generally Accepted Accounting Principles and International Financial Reporting
Standards.
Examples of the proper usage of the accrual principle are:

Record sales when you invoice the customer, rather than when the customer pays you.

Record an expense when you incur it, rather than when you pay for it.

Record the estimated amount of bad debt when you invoice a customer, rather than
when it becomes apparent that the customer will not pay you.

Record depreciation for a fixed asset over its useful life, rather than charging it to
expense in the period purchased.

Record a commission in the period when the salesperson earns it, rather than the
period in which he is paid it.

Record wages in the period earned, rather than in the period paid.

When properly implemented, the accrual principle allows you to aggregate all revenue and
expense information for an accounting period, without the distortions and delays caused by
the cash flows arising from that accounting period.
Recording transactions under the accrual principle may require the use of an accrual journal
entry. An example of such an entry for a sale on credit is:

Debit
Accounts receivable

Credit

8,000

Sales

8,000

In this entry, revenue is recorded before payment from the customer arrives, along with an
accounts receivable asset in the same amount. In the following month, the customer pays the
company, and the company records the following entry:
Debit
Cash
Accounts Receivable

Credit

8,000
8,000

The cash balance increases as a result of the customer payment, which also eliminates the
accounts receivable asset. If you do not use the accrual principle, then you are using the cash
method of accounting, where you record revenue when cash is received and expenses when
they are paid. There are also modified versions of the cash method of accounting that allow
for the limited use of accruals.

The Conservatism Principle

The conservatism principle is the general concept of recognizing expenses and liabilities as
soon as possible when there is uncertainty about the outcome, but to only recognize revenues
and assets when they are assured of being received. Thus, when given a choice between
several outcomes where the probabilities of occurrence are equally likely, you should
recognize that transaction resulting in the lower amount of profit, or at least the deferral of a
profit. Similarly, if a choice of outcomes with similar probabilities of occurrence will impact
the 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 should
tend toward recording the loss. Conversely, if there is uncertainty about recording a gain, you
should not record the gain.
The conservatism principle can also be applied to recognizing estimates. For example, if the
collections staff believes that a cluster of receivables will have a 2% bad debt percentage
because of historical trend lines, but the sales staff is leaning towards a higher 5% figure
because of a sudden drop in industry sales, then use the 5% figure when creating an
allowance for doubtful accounts, unless there is strong evidence to the contrary.
The conservatism principle is the foundation for the lower of cost or market rule, which states
that you should record inventory at the lower of either its acquisition cost or its current
market value.
The conservatism principle is only a guideline. As an accountant, you should use your best
judgment to evaluate a situation and to record a transaction in relation to the information you

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

The Consistency Principle

The consistency principle states that, once you adopt an accounting principle or method, you
should continue to follow it consistently in future accounting periods. You should only
change an accounting principle or method if the new version in some way improves reported
financial results. if you make such a change, you should fully document its effects, and
include this documentation in the notes accompanying the financial statements.
Auditors are especially concerned that their clients follow the consistency principle, so that
the 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 of
the principle.
The consistency principle is most frequently ignored when the managers of a business are
trying to report more revenue or profits than would be allowed through a strict interpretation
of the accounting standards. A telling indicator of such a situation is when the underlying
company operational activity levels do not change, but profits suddenly increase.

The Cost Principle

The cost principle is the general concept that you should only record an asset, liability, or
equity investment at its original acquisition cost. The principle is widely used to record
transactions, partially because it is easiest to use the original purchase price as an objective
and verifiable evidence of value.
A variation on the concept is to allow the recorded cost of an asset to be lower than its
original cost, if the market value of the asset is lower than the original cost. However, this
variation does not allow the reverse - to revalue an asset upward. Thus, this is a crushingly
conservative view of the cost principle.
The obvious problem with the cost principle is that the historical cost of an asset, liability, or
equity investment is simply what it was worth on the acquisition date; it may have changed
significantly 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. Thus, the cost principle
yields results that may no longer be relevant, and so of all the accounting principles, it has
been the most seriously in question.
The cost principle is not applicable to financial investments, where accountants are required
to 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 justifiable, since an
entity will not have possession of them long enough for their values to change markedly.

The cost principle is less applicable to long-term assets and liabilities. Though depreciation,
amortization, and impairment charges are used to bring them into approximate alignment
with their fair values over time, the cost principle leaves little room to revalue these items
upward. If a balance sheet is heavily weighted towards long-term assets, as is the case in a
capital-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.
The cost principle implies that you should not revalue an asset, even if its value has clearly
appreciated over time. This is not entirely the case under Generally Accepted Accounting
Principles, which allows some adjustments to fair value. The cost principle is even less
applicable under International Financial Reporting Standards, which not only permits
revaluation to fair value, but also allows you to reverse an impairment charge if an asset
subsequently appreciates in value.

The Revenue Recognition Principle

The revenue recognition principle states that, under the accrual basis of accounting, you
should only record revenue when an entity has substantially completed a revenue generation
process; thus, you record revenue when it has been earned. For example, a snow plowing
service completes the plowing of a company's parking lot for its standard fee of $100. It can
recognize the revenue immediately upon completion of the plowing, even if it does not
expect payment from the customer for several weeks.
Also under the accrual basis of accounting, if an entity receives payment in advance from a
customer, then the entity records this payment as a liability, not as revenue. Only after it has
completed 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. For example, using the same scenario as just noted, the snow plowing service
will not recognize revenue until it has received payment from its customer, even though this
may be a number of weeks after the plowing service completed all work.

The Economic Entity Principle

The economic entity principle states that the activities of a business entity will be kept
separate from the activities of its owner(s) and any other business entities. This means that
you must maintain separate accounting records for each entity, and not intermix with them
the 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 entity
for the purposes of creating consolidated financial statements for the group.
The economic entity principle is a particular concern when businesses are just 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 begins
to grow, in order to sort through earlier transactions and remove those that should be more
appropriately linked to the owners.

The Going Concern Principle

The going concern principle is the assumption that an entity will remain in business for the
foreseeable future. Conversely, this means the entity will not be forced to halt operations and
liquidate its assets in the near term. By making this assumption, the accountant is justified in
deferring 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 the
contrary. An example of such contrary information is an entitys inability to meet its
obligations as they come due without substantial asset sales or debt restructurings. If such
were not the case, an entity would essentially be acquiring assets with the intention of closing
its 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 up
the issue of whether its assets are impaired, which may call for the write-down of their
carrying amount to their liquidation value. Thus, the value of an entity that is assumed to be a
going concern is higher than its breakup value, since a going concern can potentially continue
to earn profits.
The going concern concept is not clearly defined anywhere in generally accepted accounting
principles, and so is subject to a considerable amount of interpretation regarding when an

entity should report it. However, generally accepted auditing standards (GAAS) do instruct
an auditor regarding the consideration of an entitys ability to continue as a going concern.
The auditor evaluates an entitys ability to continue as a going concern for a period not
greater than one year following the date of the financial statements being audited. The auditor
considers such items as negative trends in operating results, loan defaults, denial of trade
credit from suppliers, uneconomical long-term commitments, and legal proceedings in
deciding if there is a substantial doubt about an entitys ability to continue as a going concern.
If so, the auditor must qualify the audit report with a statement about the problem.

The Monetary Unit Principle

The monetary unit principle states that you only record transactions that can be expressed in
terms of currency. Thus, you cannot record such non-quantifiable items as employee skill
levels or the quality of customer service.
The monetary unit principle also assumes that the value of the unit of currency in which you
record transactions remains stable over time. However, given the amount of persistent
currency inflation in most economies, this assumption is not correct - for example, a dollar
invested to buy an asset 20 years ago is worth considerably more than a dollar invested today,
because the purchasing power of the dollar has declined during the intervening years. The
assumption fails completely if an entity records transactions in the currency of a
hyperinflationary economy.

The Materiality Principle

The materiality principle is the magnitude of an omission or misstatement in an entity's
financial statements that makes it probable that a reasonable person relying on those financial
statements would have been influenced by the omitted information or made a different
judgment if the correct information had been known. Under generally accepted accounting
principles (GAAP), you do not have to implement the provisions of an accounting standard if
an item is immaterial. This definition does not provide definitive guidance in distinguishing
material information from immaterial information, so you must exercise judgment in deciding
if a transaction is material.
The Securities and Exchange Commission has suggested for presentation purposes that an
item representing at least 5% of total assets should be separately disclosed in the balance
sheet. However, much smaller items may be considered material. For example, if a minor
item would have changed a net profit to a net loss, that item could be considered material, no
matter how small it might be. Similarly, a transaction would be considered material if its
inclusion in the financial statements would change a ratio sufficiently to bring an entity out of
compliance with its lender covenants.

As an example of a clearly immaterial item, you may have prepaid $100 of rent on a post
office box that covers the next six months; under the matching principle, you should charge
the rent to expense over six months. However, the amount of the expense is so small that no
reader of the financial statements will be misled if you charge the entire $100 to expense in
the current period, rather than spreading it over the usage period.
The materiality concept varies based on the size of the entity. A massive multi-national
company may consider a $1 million transaction to be immaterial in proportion to its total
activity, but $1 million could exceed the revenues of a small local firm, and so would be very
material for that smaller company.
The materiality principle is especially important when deciding whether a transaction should
be recorded as part of the closing process, since eliminating some transactions can
significantly reduce the amount of time required to issue financial statements.

The Matching Principle

The matching principle is one of the cornerstones of the accrual basis of accounting. Under
the matching principle, when you record revenue, you should also record at the same time
any expenses directly related to the revenue. Thus, if there is a cause-and-effect relationship
between revenue and the expenses, record them in the same accounting period.
Here are several examples of the matching principle:

Commission. A salesman earns a 5% commission on sales shipped and recorded in

January. The commission of $5,000 is paid in February. You should record the
commission expense in January.

Depreciation. A company acquires production equipment for $100,000 that has a

projected useful life of 10 years. It should charge the cost of the equipment to
depreciation expense at the rate of $10,000 per year for ten years.

Employee bonuses. Under a bonus plan, an employee earns a $50,000 bonus based on
measurable aspects of her performance within a year. The bonus is paid in the
following year. You should record the bonus expense within the year when the
employee earned it.

Wages. The pay period for hourly employees ends on March 28, but employees
continue to earn wages through March 31, which are paid to them on April 4. The
employer should record an expense in March for those wages earned from March 29
to March 31.

Recording items under the matching principle typically requires the use of an accrual entry.
An example of such an entry for a commission payment is:
Debit
Commission expense

Credit

5,000

Accrued expenses

5,000

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 the
commission, and records the following entry:
Debit
Accrued expenses
Cash

Credit

5,000
5,000

The 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 Period Principle

The time period principle is the concept that a business should report the financial results of
its activities over a standard time period, which usually monthly, quarterly, or annually. Once
the duration of each reporting period is established, you use the guidelines of Generally
Accepted Accounting Principles or International Financial Reporting Standards to record
transactions within each period.
You must include in the header of any financial statement the time period covered by the
statement. For example, an income statement may cover the "Eight Months ended August
31."

The Reliability Principle

The reliability principle is the concept of only recording those transactions in the accounting
system that you can verify with objective evidence. Examples of objective evidence are:

Purchase receipts

Cancelled checks

Bank statements

Promissory notes

Appraisal reports

Note that the examples shown here are of documents generated by other entities (customers,
suppliers, valuation experts, and banks). Since they are third parties, documents supplied by
them are considered to be of higher value as objective evidence than documents created
internally.
The 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 these
reserves are essentially opinion-based. In these cases, it is particularly important to justify
your actions with a detailed analysis of the reasons for the reserve. This is frequently based
on verifiable historical experience with similar transactions, and which you expect to be
repeated in the future.
From a practical perspective, you should only record those transactions that an auditor could
reasonably be expected to verify through normal audit procedures.