Concepts Vs Methods in Accounting: What’s The Difference? (Part 1)
Although Concepts and Methods are closely linked to the process of bookkeeping and accounting, there is a difference between the two. As a business owner, you need to be familiar with this difference in order to have the correct accounting framework in place.
Let us talk about the difference between Concepts and Methods in accounting.
Accounting concepts
Accounting is the process of recording, classifying, and summarizing financial transactions to provide information that is useful in making business decisions. The most fundamental accounting concepts are the double-entry bookkeeping system and the accrual basis of accounting.
The double-entry bookkeeping system is a system of accounting that uses two accounts for every transaction. For every debit, there is a corresponding credit. This system ensures that all financial transactions are accounted for and eliminates the need for manual reconciliation.
The accrual basis of accounting is a system of accounting where revenue is recognized when it is earned and expenses are recognized when they are incurred. This system ensures that revenues and expenses are matched and that the financial position of the business is accurate.
There are other important accounting concepts, such as the time value of money, the principle of materiality, and the concept of conservatism. These concepts are important for understanding financial statements and making sound business decisions.
Understanding time value of money
Time value of money (TVM) is the basic principle in finance that observes the preference for receiving money sooner rather than later. In other words, people would rather have cash in hand today than the same sum of cash a year or more from now. TVM is also the foundation for other key concepts in finance, such as present value and future value.
The idea behind TVM is that a dollar today is worth more than a dollar tomorrow. The logic is that you can invest that dollar today and earn a return on your investment. So, the sooner you receive the money, the more value it has.
There are a few factors that impact the time value of money. The most important are the interest rate and the time period. The interest rate is the rate of return you expect to earn on your investment. The time period is the length of time over which you expect to receive the money.
You can use the time value of money equation to calculate the present value of a future amount of money or the future value of a present amount of money. The equation is:
PV = FV / (1 + r) ^ n
PV is the present value, FV is the future value, r is the interest rate, and n is the number of periods.
Let’s say you want to know the present value of a $1,000 payment that you will receive in 10 years. To calculate it, you would use the equation above and plug in the values for PV, FV, r, and n.
PV = $1,000 / (1 + .10) ^ 10
PV = $600
So, the present value of the $1,000 payment is $600.
Principle of materiality
The principle of materiality states that financial information should be reported in a way that is both relevant and practical. This means that accounting information should be limited to that which is important to making business decisions. In practice, this principle is used to determine which transactions should be included in financial statements. Transactions that are considered immaterial are not reported.
The principle of materiality is based on the premise that financial information should be accurate and reliable. Transactions that are not material to the business do not need to be reported, because they are not likely to impact the company’s financial position or performance. This allows businesses to focus on the most important information, while still providing a complete and accurate picture of their financial health.
The principle of materiality is one of the most important concepts in accounting. It helps ensure that financial statements are reliable and relevant, making them useful for business decisions. In practice, the principle of materiality is used to determine which transactions should be included in financial statements. Transactions that are not material are not reported, making the financial statements more concise and manageable.
Concept of conservatism in accounting
According to Conservatism in accounting, when there is doubt about the value of an asset, the asset is not changed in value in the financial statements. The conservative approach to accounting is to understate income and asset values, and overstate liabilities. This results in a lower net worth for the company, and a lower reported income.
The conservative approach is based on the belief that it is better to err on the side of caution, and report lower numbers than to report higher numbers that may not be accurate. The conservative approach is also used to protect the company from potential lawsuits. If a company reports higher income or asset values than are actually accurate, it may be sued by shareholders or other parties who believe they were harmed by the inaccurate information.
Now that we have explained the different concepts in accounting, let us dive into the methods next.