13 Essential Accounting Concepts with Examples for Beginners

Firstly, this is required by the regulations. The tax authorities also rely on the accounting numbers, even though they also have their own rules.

Secondly, aligned accounting measurement provides comparable information to the investors. Besides, the stock exchanges require such accounting records to assess whether the companies can go public.

Even if you do not plan to make your business public, solid accounting records also help you understand and plan for the business, and sell the business better if this is your plan.

Thirdly, this method is recognized by the financial institutions. When they assess the business for financing purposes, they look into the financial statements, the products of accounting.

In my opinion, it depends. Some accounting methods can introduce additional issues to the business assessment. Nowadays, investors are increasingly interested in cash flows, especially the free cash flows – you will learn in another post.

Nevertheless, most business ratios and the cash flows derive from the accounting. Thus accounting is still prevalent.

The ‘accounting conventions’ are 4 specific principles: full disclosure, consistency, materiality and conservatism. The meaning of each will be explained below. Other principles, on the other hand, are called ‘accounting concepts’.

Accounting standards include both conventions and concepts. It is not necessary to distinguish them to understand accounting concepts.

Or Economic Entity Assumption, is an accounting concept to set boundaries for the business. Accountants assume the business conduct the transactions as an independent entity separated from its owner, or other entities. One entity maintains one accounting book.

For example, Emily has a company named Service.co, providing services to customers. The Service.co gets a loan of $5,000, meanwhile, Emily also gets a personal loan of $1,000. Only the $5,000 will appear in Service.co’s accounting book.

If the business grows and Emily opens a subsidiary Service.co UK registered in United Kingdom, the Service.co UK is an independent entity, and needs to maintain its own accounting book. Assume Service.co UK gets a loan of $3,000, this $3,000 will not appear in Service.co’s book either.

In summary, Emily has her personal finance and 2 accounting books to maintain:
– Service.co: loan $5,000
– Service.co UK: loan $3,000
– Personal budget: loan $1,000

You may question: Emily owns both Service.co and Service.co UK! Won’t she want to know how these 2 companies’ combined performance? Of course she does, therefore we have another entity named Service Group:
– Service Group: loan $8,000 ($5,000 + $3,000)

You will notice Emily’s personal loan is not a part of the Service Group. This is because Emily’s companies are incorporated and regulated by the corporate laws. There is a clear line between the companies and the owner, to protect the owner from the liabilities. Now you know why some companies have a suffix “limited”.

Nowadays, companies can have very complex corporate structure involving holding companies, trusts, and other. Nevertheless, each entity needs to have its own book.

So this is the business entity assumption.

Going-concern is an accounting concept assuming the business will continue to operate with implied future economic activities (e.g. production, procurement, sales, etc.).

Why we need this assumption? Because if a company liquidates (a fancy way to say going bankruptcy) or shut down, it makes no sense to record how much money the business will collect from the customers or will pay to the suppliers.

Liquidation accounting is a different accounting methodology. This post will focus on the normal case that Emily’s companies will continue to operate.

A full disclosure concept is an accounting convention and an accounting concept requiring a business to fully disclose its economic activities.

For instance, no matter it is big transaction like buying a production machine, or small transaction like buying a box of pens, you must record all the transactions to the accounting book.

If you are in France and operating a company like Evian, taking water from the nature paying no specific cost per ml., how to record this activity?

Here comes the money measurement concept, an accounting concept indicating that only monetary transactions will be recorded in the accounting book. You do not have to record the activities that does not or cannot be measured in money.

But the recent emphasis in ESG (environmental, social, and governance) and carbon footprint expands this concept: many companies start to maintain a carbon accounting book, not using money but using carbon emission as the measurement unit. If you are interested in the carbon accounting, please leave a comment.

Accounting period concept, or period concept, is an accounting concept that takes a period as the time frame for financial reporting. Transactions occurred during this period will be included in the financial reporting for this period.

Usually, an accounting period is one month, one quarter, or one-year (namely a fiscal year). Note that fiscal year does not necessary equal to the calendar year. That is why you see some companies have a year-end as of July 31, August 31, etc.. The quarters depend on the fiscal year.

The reasons those companies set up a fiscal year that is different from calendar year vary. One could be the cycle of their business activities. For example, for businesses that are super busy from November to March may consider a year-end by the end of July or August.

Most small and medium companies set the fiscal year the same as the calendar year.

Consistency is an accounting convention and an accounting concept that business should maintain the same accounting methods throughout the accounting periods to provide comparable information to the stakeholders.

The primary purpose of consistency is for comparison, not to prohibit change in accounting methods. After all, accounting standards themselves change over time. For public companies, if there is any change in the accounting methods, they need to restate the financial statements for several prior years. So it is indeed better to keep the accounting consistently,

Materiality accounting concept states that all transactions that reasonably impact stakeholders, especially the investors, must be reported in detail in the financial reporting. This concept also determines whether a discrepancy resulted from omission or misstatement would impact a reasonable user’s decision-making.

The material items could be transaction occurred or potential transactional in the future.

Firstly, for the transactions occurred, their materiality is usually determined by % of revenues or % of assets. The threshold is usually 3-5%. For example, if Emily’s Service.co makes $10,000 revenues per year, expenses equaling to or exceeding $300 ($10,000 * 3%) will be considered material.

You may say: ‘wait. You just said we need to FULLY disclose. Now you say there could be omission?’

Confusing, I know. The rule of thumb in practice is not to hide transaction on purpose, but immaterial mistakes are acceptable.

For example, Emily tried to fully disclose every transactions for Service.co, but she did not remember a purchase of $20 in 2023 because there was a late process of payment. So she did not include this $20 in her accounting book in 2023. Now the 2023 is close.

She did not intend to hide the transaction, plus the transaction is not material (< $300), so this is ok.

Secondly, for the transaction in the future, examples include potential lawsuit or other foreseen expenditure. Because it does not involve money, you will not include it in the accounting book (as stated in the money measurement concept), but as additional note in the financial report.

Auditors also adopt this concept during the auditing engagement to determine whether they will conduct in-depth auditing procedure to examine a specific account or transaction.

This is an accounting convention and accounting concept saying that accountants are conservative in assumptions and estimates. In another sentence, when things are not black-and-white clear, accountants tend to understate than overstate, and always think about the worst case.

Whether this concept deeply affects an accountant personally? I will leave it to you to judge.

Accrual concept is an accounting concept stating that accountants record the transaction when it essentially occur rather than when it is paid.

For instance, if Emily signs a contract in 2023 to purchase a software, but the payment will actually happen in 2024, Emily still needs to record the purchase in 2023.

A fun fact: the accrual concept opens a window to revenue manipulation around the year-end. For example, a company may try to push a big sale that will happen in the next fiscal year to the current fiscal year if their current year hasn’t been so great. This is also a key area auditors will pay close attention to.

This is the key grammar of the accounting language! I will begin with the 5 elements of accounting:
– Assets
– Liabilities
– Equity
– Revenues
– Expenses

The first 3 elements are in the balance sheet and are components of the accounting equation:
Assets = Liabilities + Equity

To understand the equation, you can think of buying a house worth $1mn. You put a downpayment of $400k and take a loan from the bank for $600k. The $1mn is the Assets, $600k loan from the bank is the Liabilities, and the $400k is the Equity.

The assets are total value of what the business can control, while the liabilities and equity are how the business finance what it can control.

Then, accounting records transaction in 2 sides: debit and credit. Here is the summary of how to record the 5 elements:


The assets will grow with debit and decrease with credit. To maintain the balance of the equation, the liabilities and equity will grow with credit and decrease with debit.

The profit generated by the business will grow its equity. So revenues will grow with credit and decrease with debit – the same direction with equity, while the direction of expenses are the opposite.

You may wonder when the profit grow the equity, what about the asset to equal the growing equity?

Great question! When the revenues occur on the credit side, the debit side of the transactions is normally cash or accounts receivable (assets); when the expenses occur on the debit side, the credit side of the transaction is cash (assets) or accounts payable (liabilities).

It indicates that, when you are making profit (revenues > expenses), your assets will also grow in the format of cash, or net of receivable and payable.

The realization concept is to recognize revenue when the delivery is complete and one can reliably determine the value of an exchange of goods or services.

The accounting principles dedicate a full standard for the revenue recognition. The rule of thumb is whether the benefits and the risks are fully transferred. And in practice a simple way is to check the contract.

For services, if the contract determines that the customer must pay when certain action is done for the customer, this certain action is the signal to recognize the revenue.

For physical product, 2 methods are allowed: recognizing at shipping out (EXW, Ex Work), and recognizing when the products arrive the destination (DAP, Delivered at Place). To choose the better one, you may check the contract to see whether the customers will absorb the risk of shipping. If so, recognize at shipping out.

But if you will absorb the risk of shipping but cannot determine when the the products will arrive, it is acceptable to recognize at shipping out too.

The matching concept indicates that the businesses report the expenses at the same accounting period as the revenues they relate to. As a result, the expenses and revenues are matching in the income statement, a.k.a. Profit & Loss Statement (P&L).

For instance, Emily purchased a software dedicated to one of her customer in 2023. Emily will deliver the services in 2024, and thus she will record the revenue in 2024. Although Emily purchases and receives the software in 2023, the expenses should be recorded in 2024.

Cost concept is an accounting concepts stating that the transaction should be recorded at cost, even if the market value would be different.

For example, the market value of a house is $1mn. But for whatever reason, you can buy it at $900k. You will record the transaction at $900k.