We thought it might help those new to accounting if we explained a few simple but key concepts.

 

First and foremost there is the question of the entity. Accounting records reflect the financial activities of a specific business or organization, not of its owners or employees. It is always important to identify who the transaction relates to. And just to be clear, this doesn't just apply to companies and the like. If a sole trader runs a business, they should keep their business transactions separate from their personal transactions. Effectively this means they should have separate bank accounts for the two.

 

Then there is the accruals concept. Revenue and expenses are recorded when they occur and not when the cash is received or paid out. Obviously, the timing of the cash is important - and especially if you're GST-registered on a payments basis. But profit and loss is calculated regardless of whether or not items have been paid.

 

Closely aligned with this is the accounting period. While accounts are for a specific year, there are other periods within that. For example, most GST is done on a two-monthly period. And most internal procedures are done on a monthly basis. Some are even done on a weekly or semi-monthly basis. So it is important to get the dates right. That means unless the cash is paid with the transaction, or at least within the same month or shorter time frame as appropriate, the transaction (e.g. invoice / bill) should be entered with its date, and the payment entered with its correct date. This latter is particularly important to make bank reconciliation's simpler.

 

Also aligned is the concept of matching periods. Transactions affecting both revenues and expenses should be recognized in the same accounting period.

 

Consistency is also an important concept. Generally, most modern systems will suggest a repeat for transactions from the same supplier - not always correct but a big step along the way. Otherwise, you can look back to see what was done for a similar transaction last time.

 

When preparing accounts, the assumption is that this is a going concern. If this business is expected to cease in the near future, you need to talk with an advisor to avoid making expenses non-deductible.

 

Another key concept is the accounting equation: total assets equal total liabilities plus owners' equity. Every transaction affects at least two accounts, one positively and one negatively. We generally call these debits and credits. A lot of people get hung up on these, and some modern systems have even taken steps to avoid them. But put simply, a credit shows where funds have come from, and a debit shows where funds have gone to. While we can't go through this in detail in a brief article, hopefully, an example will help. Let's imagine we've bought a computer for the office. We would credit the cash used to pay for it and debit the computer asset. If we had bought it on account, we would credit the "creditor" to whom we owed the money instead of cash.

 

Another concept is cost basis. Asset values recorded in the account books should be the actual cost paid, and not the asset's current market value. Now, this does not always reflect the contortions necessary for tax purposes. If you have investments then the tax may be calculated on a different basis, which is beyond the scope of this article. However, there is one common exception. Inventory is valued either at cost or market value (whichever is lower).  Generally, any change in the market value of an asset or liability is not recognized as a profit or loss until the asset is sold or the liability is paid off (realised).

 

Finally, there is the unit of measurement. Financial data should be recorded with a common unit of measure (NZ dollar for Kiwi accounts). This does bring in complications where more than one currency is dealt with. Generally, the procedure (unless the exchange rate for this transaction has been fixed in advance) is to use the exchange rate at the date of the liability being incurred. When it is paid the difference is put to a foreign exchange variation account.

 

There may be other fundamental principles that you feel we should add, but these are the ones that we deal with regularly. As accountants, we assume everyone thinks the same way, but experience shows otherwise.