Cambridge IGCSE Accounting(0452)/O Level Principles of Accounts(7110) Notes: The Prudence concept and the Business entity concept

  • In another topic you were introduced to the idea of accounting concepts
  • These are the underlying principles that govern the accounting discipline
  • In this topic we will look at the following concepts:
  • The Business Entity Concept
  • The Prudence Concept

Business Entity Concept

  • You might have noticed that the business entity concept is not mentioned in the introduction to accounting concepts mentioned above
  • While that might be the case it is a principle that we have been universally applying thus far
  • The concept states:

Transactions associated with a business must be separately recorded from those of its owners or other businesses

  • As a result transactions that involve the infusion of benefits into the business are treated as capital injections
  • For example when the owner uses their own truck worth $5000 into the business:
    1. We credit the Capital Account with $5000
    2. Motor vehicle account (asset) is debited with the $5000 amount
  • Withdrawals by the proprietor are entered in the Drawings Account
  • The Current Account is also used in cases of Partnerships
  • Other accounts are used in the case of Limited Liability businesses (companies)
  • The name of the proprietor(s) is not used when recording transactions in their own books

Prudence concept

  • The prudence concept states:

Revenue must not be overstated and losses/expenses must be written off as soon as they occur

  • What this means is that sales and other revenue must not be recorded in the books unless we know that they have occurred
  • We should not for example record as a sale, a verbal promise to buy goods as a sale
  • Sales must only be recorded when the contract of sale has been signed
  • Similarly expenses such as bad debts must be recorded as soon as they occur
  • Also a provision for doubtful debts must be set aside to cover debts that are likely to be bad
  • Profits are not to be anticipated when they have not yet been realised
  • All losses must be recorded
  • Prudence is the most important concept and if there is conflict between prudence and another concept prudence prevails

To access more topics go to the Cambridge IGCSE Accounting(0452)/O Level Principles of Accounts(7110) Notes.