All accounting information, whether for decision support or for accountability purposes, relies on the same foundation, the collection and processing of financial data. This process starts with five fundamental concepts; the accounting entity, going concern, accounting period, transactions and the accounting equation.
Accounting data is collected for an accounting entity – the economic unit for which financial reports will be prepared. The entity is accounted for separately from its owner or other accounting entities within the same organization. An accounting entity need not be the same as a legal entity. For example, a department within a company or a university may well be an accounting entity, but only the company, or the university is the legal entity – able to enter contracts and take legal action in its own right.
Accounting entities are generally assumed to have indefinite life – that is, they will exist for the foreseeable future, unless there is clear evidence to the contrary. A few entities have specific lives – Olympic Games organizing companies and entertainment concert tour companies are examples. Some other entities may run into serious financial difficulties that threaten their continuing existence. However, most entities are assumed to be going concerns and, as we will see, their financial statements reflect this key assumption.
Because of the going concern nature of accounting entities and the need to report to both management and external parties at regular intervals, a further concept is adopted – that of the accounting period. This divides the indefinite life of the entity into finite reporting periods – appropriate to the use to be made of the financial reports. The most common periods are monthly for management (internal) purposes and annually (or six monthly) for generally purpose (external) reporting.
Each accounting entity undertakes some form of economic activity. These activities give rise to accounting transactions – economic events that effect the financial position of the business and that can be reliably measured. Common examples of accounting transactions are sale for cash or on credit, purchase for cash or credit, bank loans, amounts owing to suppliers, funds provided by owners. Generally, events are not recognized as accounting transactions until they are substantially completed. For example, orders placed by customers are incomplete until goods or services are provided. Such orders are not recognized as transactions, although they represent important decisions. When an accounting entity begins operations, its transactions are recorded on source documents – such as invoices, receipts, checks, and bank statements. From there, the transactions are entered in the financial records of the entity – according the certain procedures that ensures that the records are accurate.
Transactions are recorded according to their impact on the accounting equation, which represents the financial position of the entity. At the very beginning of a business, the entity receives funds (capita) from its owner and may borrow further funds (loans) from outsiders. The entity now has an asset (cash) but owes this amount in total to its funders: as owners’ equity and liabilities. In the fundamental accounting equation, this is expressed as: Assets = Liabilities + Owners’ equity.