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0:01
Hi! Welcome to a quick lesson on the 'Accounting Concepts and Principles'. And the accounting concepts and principles will form part of any 'Introduction to Accounting' course. Okay, in the next few minutes we're going to learn 7 accounting concepts. Every student, bookkeeper, accountant, MBA candidate MUST know, and understand, these concepts and principles if they're going to become proficient as an accounting professional. Essentially, if you study accounting this
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is week 1, lecture 1, slide 1 stuff, in your accounting knowledge journey. Okay, some background. Now, accounting information is used for 'decision making'. Reports and other accounting information are produced so management, investors, creditors, the government, or other stakeholders can take actions based on this accounting information. Um, if you further look at it, like, accounting is the language of business. It's how you can communicate a business's activity
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over time. Or at a particular point in time. But if you consider every organization type, every organization size, every organization location, how can we all speak the same language? And make the best decisions we were just talking about? The answer to this is that, accountants follow a basic set of concepts and principles whenever they practice accounting. All financial accountants follow these principles globally. And by doing this they consistently achieve
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reliability, relevance, and comparability, in the information they produce. And that's what we are going to be learning today: The 7 accounting concepts that you have to know, if you're going to be an accounting professional. Okay so let's get to the 1st concept, and this is the 'Entity' concept. And this is when we focus on the accounting entity. What this means is that when we perform the act of accounting, and present accounting information, we are
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presenting accounting information, and measuring accounting data, about a particular entity and that entity alone. Now an entity, is kind of an abstract sort of concept. But all it's really referring to is perhaps an organization, or a section-- or a section of an organization, like a department or a division. But the key idea is: Whatever entity you're reporting or measuring, will stand apart and separate from every other entity, every other organization, and separate
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from individuals themselves. What you do is: You draw a strict boundary around the particular entity, and you only do the accounting for your particular-- for your particular accounting entity. What this means is that when you present your accounting information, ah, you don't have your data, and resulting reports, mixed up with other uncontrollable or irrelevant entities. So hypothetically, if you're reporting on the marketing department, you want people who are going to make
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decisions about your reports on the marketing department, only to act on the marketing department information! You don't want outside entity information, like the production department, to have some of their particular data filter into your entity, and thus have confusion and poor decision-making based on the reports you produce. So that's the-- that's the accounting entity concept. Um, yeah, an example again is, um, instead of a department, I mentioned that you keep
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individuals and entities separate. (So) perhaps you're a micro-business person and you run a home business, and you have certain business expenses. And you have business income, within your particular home office. The entity concept tells you that you keep your business transactions, so your micro business transactions, separate from your personal life transactions. So if you're producing financial reports, you would only have financial reports on business revenue
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and business expenses in running a micro business, and you would separate your individual personal expenses out of those accounting reports. The 2nd concept is the 'Accounting Period' concept. And this is the focus on the accounting period. The 'accounting period' is simply a unit of measurement. It's-- it's a time period. The idea is that the life of an organization is indefinite; could be one month, one year, ten years, or even one hundred years ...or even more(!) for some of the older
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organizations that we have in the world today. So to get value out of our accounting information reports, we have to have some sort of set time period where we can make some sort of comparison between report and report. There will be no-- it's an extreme example, but if you were the Chief Financial Officer of the Ford Company, and this company been going since the early 20th century, it would seem kind of extreme to have one profit & loss report for the
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hundred years, or the life, for the period. You wouldn't have one profit & loss report from 1900 to 2015. That that would just be impractical, and wouldn't serve much purpose for decision making. So what accountants do is that they break the life of an organization into particular time periods, and these are known as accounting periods. Often there are regulatory-required accounting periods. So, for instance, if you're listed on a stock exchange you often have to-- I think
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you ALWAYS have to, produce an annual report if you're a public company. And you have to produce an annual report for your stockholders. But there's also, ah, int-- internal accounting periods which you can set yourself. So for instance, management often needs accounting data much more regularly than stockholders, so an accounting period for management reports may be monthly, or even weekly. They may get weekly sales reports, or monthly cost reports, and in
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that case the accounting period is a month. The great-- the purpose is comparability between periods. So you're able to compare one period to the other. And having a beginning-- a beginning to a period, a middle to a period, and an end to a period ...so it's not one long continuous activity. This adds to relevancy of your accounting information, and allows better decision-making when you have more timely reports. The examples that we gave are: the annual reports of
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public companies, or the monthly management reports for internal management. All right the 3rd principle is the 'Cost' principle. And this is based on that the idea that accounting value, is based on transaction costs. Now these may be 'historic' costs, which is an important concept, or 'fair value' costs, or fair value, which is another important accounting concept. And for both of these, whether its historic cost or fair value, is that we don't record transactions or
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values on what we 'think' particular items are worth, we always base our values on financial 'transaction evidence'. So if we're using historic cost then we may use invoices or receipts to prove the value of our transactions, and to prove the value of our expenses or assets. And if we're using fair value, then we may use a verifiable valuation documentation, if we're keeping values at fair value. It's important to note that we don't record
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transactions for items on what we think they are worth. Now we may buy an item for $100, for example, and we may honestly believe that we've got an absolute bargain and that this item is really worth $10,000! Now even though we paid $100 for it, we really think it's worth $10,000, and we got an absolute bargain. We would never record that transaction, or the value of that particular item, for $10,000, because we think that's
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what they're worth. We have to base it on evidence, and in particular the transaction that we went through, and use those, um, and use those are values. What this does, is by relying on transaction costs we have an objective measure of value. It's not subjective, or what we think they're worth, or what we assume they're worth. When there's a transaction that occurs between knowledgeable, willing parties, there's a buyer and seller, then we know that that's an objective measure of
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value. The seller thought was the correct value, the buyer thought it was the correct value, and we have that verifiable cost to enter into our accounting information. This allows our decisions to be made with more certainty, when we had this objectivity, as to the reliability of our accounting information. And with that reliability and certainty then ideally our decisions will be better. All right, an example. An example is where I talked about
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historic costs. Our example could be where if a business is buying an office building, we would have documentation about how much we paid the office building, maybe $100,000 for the building (a very cheap building, um, in some parts of the world), and our historic-- we would enter the $100,000 into our accounting information system, or accounting data. That's what we paid for it. It's what the seller thought it was worth. It's what we
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thought it was worth as a buyer. And we have evidence of that. Alright, the next concept, the 4th one is the 'Matching' principle. And this is the idea in that we 'match' expenses against the income generate-- against the income they generate. Now, if we-- if we think of a business as a system, we can look at it like: our expenses are the inputs into the business, so we spend money on things to go into the business. And then income is generated from selling the outputs. So we
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pull things into the business that cost money, and they're our expenses. We perform a transformation on those. And then we generate outputs, which are later sold, and that is our income. And it's one system. And if we're going to get an accurate measure of profit, which is simply income minus expenses, then we need these inputs and outputs to match up, to line up against each other, to get a true reflection of profit. And that's the greatest benefit of the matching
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principle. We do get a good measure of profit, which is just simply income minus expenses. For example, if we have our cost of goods sold in the inventory: So if we are-- if we're selling widgets for $200 at our corner store, but the widgets costs $150 to stock. So we pay our supplier $150, we put them in our shelves, and then we sell them for $200, (then) we want that $150 of the inventory to be recognized as an expense (which is 'cost of goods sold'), um, at the
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same time that we sell the widgets for $200. So there should be $200 for income, $150 for cost of goods sold (which is our expense), and those two should occur at the same time. And that's an example of the matching principle. And by having those two amounts at the same time, we get an accurate reflection of profit of selling those widgets. Okay the 5th concept, which is the 'Profit Recognition' principle. And this is the idea that we only recognize profit or-- or revenue,
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(which is, ah, profit is just revenue minus expenses, or income minus expenses), so we only recognize profit or revenue when it is earned, and it can be reliably measured. And we earn our income, and we earn our revenue, when we sell the good or carry out the service ...and this is not when the cash is received. So, there are two main points: Cash has nothing to do with when we recognize revenue and income, um, it's part of a accrual accounting which is something that you'll learn about, or
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will cover in another lecture or lesson. Um, it's that, ah, accrual accounting states that you never recognize revenue or income when cash is received, or-- or they're independent of each other. You recognize revenue when you EARN the revenue. And if you're selling goods or-- if you're selling goods you earn the revenue, generally when you sell the good. Or if you're a service organization, you earn the revenue when you perform the act of the service. As an example: If
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you're a bookkeeper and you're running a bookkeeping business you may only collect payments from your clients, um, on a quarterly basis. You may not--- actually scratch that! You may collect them more regularly than quarterly, but you may bill them at the end of the month, and you may give them 45 days to pay that invoice. So it may be, um, it may be more than 45 days from when you perform the service, as to when you receive the cash for the
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payment. Now the profit recognition principle says you recognize the the income or the profit when you perform the bookkeeping service. So you would recognize that on the Monday, and Tuesday, then Wednesday, the Thursday, and the Friday when you were acting on their behalf. And not when you collect the cash. You recognize the revenue when you perform the service. Something on top of that, is that it has to be reliably measured. I just gave an example of a bookkeeper: if
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you're carrying out a bookkeeping service, and you can't reliably measure the work that you're doing, and can't put a transactional value (as we're going back to the cost principle), and you can't put a value on that work THEN you can't recognize revenue either. So I dwelled a bit on, um, when you reco- ah, on earning the revenue ...(but) it also has to be reliably measured. And by reliable measured you have to know the value of it, based on the cost principle. Alright,
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the 'Conservatism' principle. This is the idea that you "anticipate no profit, and you anticipate all losses." There-- there's kind of the running joke that the accountant is the negative one in the organization, or the one with the cranky mood, or the bad attitude-- not bad attitude, but the negative one. It's based on this conservative principle. And as an accountant you kind of have to be the cold shower for all the optimism in the organization. If
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everyone's too optimistic, it's too easy for optimistic valuations, optimistic income recognition, and other, um, inaccurate data to bleed its way into the financial reports and the financial data. So you have to be very conservative, in-- um, and remove the optimism in the way you record your information, and the way you measure your results. If you anticipate no profit, and anticipate all losses, and keep that at heart, um, that's the sort of attitude
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you have to take. So you wait-- you have to be 100% certain that you've earned a profit before you record it. And if you think you're likely to experience a loss, then recognize it early. As an example: You could be a-- you could be an accountant, (and) the sales manager might come over to you and say, "Oh, listen then, we've got a big contract with, um, company XYZ, um, we really think they're going-- going to sign the contract, and um buy-- and sign
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a big deal with us and we're going to recognize a bunch of revenue very, very, very soon I'm almost-- it's almost a dead certainty that we're going to sign this contract with company XYZ. As an accountant, you shouldn't recognize that revenue at that stage it's not good enough that the sales manager simply says, "Yeah it's looking good you know, you've been saying all the right things so far." You would have to wait for company XYZ to sign the contract, or to officially
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sign up and make sure it's a 100% certain, not-- not 95% certain not 97% percent. So it has to be 100% certain before you recognize revenue. About anticipating all losses... You may be working in a mining organization, um, a particular-- a particular deposit you know in a region you've been-- you've been searching for a particular diamonds or something, I don't know(!), you've been mining for diamonds and so far no diamonds have
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shown up at the mine. Now if everyone in the organisation is saying, "No, no.. we're sure there are diamonds in the mine, we're sure there are diamonds in the mine, nothing's shown up so far, but we're feeling pretty good." As the accountant it's up to you to be conservative and say, "Listen, you know?!?!?", and recognize the losses on that mine, that, um, hasn't borne fruit. 'Anticipate no profit, anticipate all losses', that's the key phrase. Alright, a
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final one. This is, ah, the 'Going Concern' principle. And this is the idea that you assume the business' continuity for the foreseeable future. If you make that assumption, it adds to the reliability of the data. And by using the going concern principle the values remain the most accurate ...with this assumption. The best way-- the best way to explain this is, is with an example. Now if you assume that the business is going to continue for the
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foreseeable future, that's what--- that's one assumption. If we look at an extreme: where we assume that the business is about to go OUT of business a lot of our valuations don't hold up anymore. So we may have (we talked about) that office building that we reckon was worth a million dollars at one stage. If we think we're going out of business next-- next week then I'm sure we would take-- we would want to sell that office building very quickly, and we may accept
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much less than a million dollars. The value in our accounting record might be a million dollars, but if we're going out of business we may sell it for $200,000. So, by the idea that, if we don't assume that the business is continuing into the future for the foreseeable future, our valuations can be kind of messed up. Also at the other extreme if we assume that the business is going to-- is going to go on forever, or go into perpetuity,
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this kind of again contradicts the conservatism principle. We'd like the business to go forever, but we're not being a hundred percent conservative if we made that assumption. Very few businesses last for-- for eternity. So we've got to take a happy medium between those, and we just-- we just make the assumption that for the foreseeable future the business will continue, and our accounting information will hold it up to the most scrutiny, and
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be the most reliable ...and that's the most relevant for our decision-making, if we make that assumption. And they're the seven accounting concepts. It's taken me longer than expected to explain! Thanks very much for listening. Um, get in contact if you need any clarification. I can't always say everything 100% in these lectures, or lessons, or videos. But if you get in contact, I can explain things a bit better. So thanks for listening!
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