'Business Entity' is formed as a separate entity to engage in business activities, charitable work or other activities allowable. Most business entities are formed to sell a product or provide a service. A business entity is considered separate from the owners and therefore should be treated separately.
The personal transactions of the owner should not be recorded through the business account unless these personal transactions are adding or withdrawing resources from the business.
Example: A personal transaction through the business
- Owner pays his personal rent from the business account.
- Rent payment cannot be recorded as an expense in the Profit & Loss Account (P&L).
- The full rent amount must be recorded through the financial books as owners’ drawings, however, if claiming partial home office space, this will be reflected in the P&L.
Your accountant will be able to advise on the legalities of these transactions.
The rent is a personal cost for the owner NOT the business, but the owner is using the business finances to pay rent.
The money is not available for the business and should be withdrawn and reflected in the financials.
This provides an accurate trail for the auditor to follow the reasoning for the transactions. It can also help reduce questions during an audit.
'Going Concern' is an accounting term for a company that has the resources to continue trading into the foreseeable future.
The term can also refer to the company’s ability to make enough money to stay afloat and avoid bankruptcy. In other words, the company will not have to liquidate or be forced out of business in the future.
'Matching Principle' is an accounting principle that requires expenses to be reported in the same period as the revenues resulting from those expenses.
Example: Matching transaction through the business
Cost of Goods Sold (COGS):
Most business purchase stock in bulk to be sold at a future date. A lot of people enter this stock purchase into the accounting system as an expense, when they pay for it.
As a result, the profit in that accounting period is greatly (and incorrectly) reduced. The next month sales are made, but since no stock purchases are made, the profit looks amazing. This goes against the Matching Principle.
Scenario 1 – Matching Principle not applied - Not good practice
All stock purchases (Inventory) are recorded against COGS in the P&L when the payment is made. The profit appears to fluctuate widely, which can lead to poor decision making.
Scenario 2 - Matching Principle applied
Total Stock purchases are recorded against the inventory account on the balance sheet. Profit is more accurately reflected on month-to-month basis, leading to more informed decision making.
'Accounting Period' is an established range of time for which financial reports have been prepared. This could be on a monthly, quarterly or annual basis.
Companies are required to prepare financial statements on an annual basis, however, most companies will also prepare financial statements on a monthly basis. Although the monthly accounts might be invaluable for companies, they should still encompass the matching principle/accrual accounting/adjusting journals to be truly insightful for analysis work.
Many businesses choose to align their annual accounting period with the Tax year in the country they are based in. This can make the Tax calculations a little easier, but it is important to note that a business can choose to start their financial year from any point.
'Consistency Principle' ensures similar and consistent accounting procedures are used by the business year after year. This allows potential investors to analyse, compare and make sound judgments on the financials. It ensures visibility of the numbers.
If the accounting methodology is constantly changed, the monthly or annual reports will not be comparable and the information could be more misleading than helpful.
'Conservatism Principle' outlines that, where there are a number of ways to value a business transaction, the lower value must always be chosen.
'Materiality Principle' is relative to the size and particular circumstances of a particular business.
Business transactions that influence a decision are material and therefore must be recorded properly.
Information is material, if its omission or misstatement on the financial statements (IASB Framework) could influence the economic decisions made by management.
A mistake that generates a small misstatement may be considered immaterial and thus may not require correction or attention.
'Objectivity Principle' states that each transaction recorded in the financial statements should be supported by some form of unbiased documentation.
For example, when A2X sends the journal or invoice to your accounting system, the raw settlement data file from Amazon is sent along with it. This file attachment is the unbiased documentation required to support the posting.
Financial reports should be produced using only factual and verifiable data. They should be free from bias and prejudice and never a subjective measurement of values.