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3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements

The Foundation of Accounting​

Accounting is built on a foundation of principles, assumptions, and concepts that ensure consistency, accuracy, and comparability. These foundational elements guide how transactions are recorded and how financial statements are prepared. In Luxembourg, these principles are incorporated into PCN standards and legal requirements.

Accounting Principles​

The Cost Principle​

The cost principle states that assets should be recorded at their original cost (historical cost), not their current market value.

Why it matters:

  • Provides objective, verifiable basis for recording
  • Prevents subjective valuation
  • Ensures consistency

Example: Marie purchases kitchen equipment for €15,000. It should be recorded at €15,000 (cost), not at its current market value of €12,000 or potential resale value.

Luxembourg Application: PCN requires assets to be recorded at cost. Depreciation reduces the carrying value over time, but the original cost remains the basis.

The Revenue Recognition Principle​

The revenue recognition principle states that revenue should be recorded when it is earned, not necessarily when cash is received.

Why it matters:

  • Matches revenue with the period in which it was earned
  • Provides accurate picture of performance
  • Follows accrual basis accounting

Example: Marie provides catering services in November but doesn't receive payment until December. Revenue should be recorded in November when the service was provided.

Luxembourg Application: Luxembourg follows accrual accounting. Revenue is recognized when earned, regardless of cash receipt timing.

The Matching Principle​

The matching principle states that expenses should be recorded in the same period as the revenues they helped generate.

Why it matters:

  • Provides accurate measure of profitability
  • Matches costs with related revenues
  • Shows true performance for each period

Example: Marie purchases ingredients in November that are used to prepare meals sold in November. The cost of ingredients should be recorded as an expense in November, matching the revenue from those meals.

Luxembourg Application: PCN expense accounts (Class 6) are matched with revenue accounts (Class 7) in the same period.

The Full Disclosure Principle​

The full disclosure principle requires that all information that could affect users' understanding of financial statements must be disclosed.

Why it matters:

  • Provides complete picture
  • Enables informed decisions
  • Ensures transparency

Example: If Marie's restaurant has a pending lawsuit, this must be disclosed in the notes to financial statements, even if the outcome is uncertain.

Luxembourg Application: Notes to financial statements (Annexe) must include all material information required by PCN and Luxembourg law.

Accounting Assumptions​

The Economic Entity Assumption​

The economic entity assumption states that a business is separate from its owners and other businesses.

Why it matters:

  • Keeps business and personal transactions separate
  • Enables accurate business reporting
  • Required for legal compliance

Example: Marie's personal grocery shopping should not be mixed with the restaurant's food purchases. They are separate entities.

Luxembourg Application: Even sole proprietorships must maintain separate business records. This is especially important for tax purposes.

The Going Concern Assumption​

The going concern assumption assumes that a business will continue operating indefinitely, not be liquidated in the near future.

Why it matters:

  • Allows assets to be recorded at cost (not liquidation value)
  • Enables depreciation over useful life
  • Basis for long-term planning

Example: Marie records her equipment at cost and depreciates it over its useful life, assuming the restaurant will continue operating.

Luxembourg Application: Financial statements are prepared assuming going concern unless there's evidence to the contrary.

The Time Period Assumption​

The time period assumption divides business activities into specific time periods (months, quarters, years) for reporting purposes.

Why it matters:

  • Enables periodic financial reporting
  • Allows performance comparison
  • Required for legal compliance

Example: Marie prepares monthly financial statements to track performance, even though the business operates continuously.

Luxembourg Application: Luxembourg businesses must prepare annual accounts. Many also prepare monthly or quarterly statements for management.

The Monetary Unit Assumption​

The monetary unit assumption states that only transactions that can be expressed in monetary terms are recorded.

Why it matters:

  • Provides common measurement unit
  • Enables aggregation and comparison
  • Practical limitation

Example: Marie records sales in euros (€). She doesn't record "good customer service" as an asset, even though it has value.

Luxembourg Application: All Luxembourg accounting is in euros (€), the official currency.

Accounting Concepts​

Accrual Basis vs. Cash Basis​

Accrual Basis Accounting:

  • Records transactions when they occur (revenue when earned, expenses when incurred)
  • Required for most businesses in Luxembourg
  • Provides more accurate picture of performance

Cash Basis Accounting:

  • Records transactions when cash is received or paid
  • Simpler but less accurate
  • Generally not allowed for businesses in Luxembourg (except very small operations)

Luxembourg Requirement: All businesses subject to PCN must use accrual basis accounting.

Materiality​

Materiality refers to the significance of an item. An item is material if its omission or misstatement could influence users' decisions.

Why it matters:

  • Allows immaterial items to be handled efficiently
  • Focuses attention on significant items
  • Practical application of accounting principles

Example: A €5 error in a €100,000 financial statement is immaterial and may not require correction. A €50,000 error would be material.

Luxembourg Application: Materiality guides disclosure requirements in financial statements and notes.

Relationship to Financial Statements​

These principles, assumptions, and concepts directly affect how financial statements are prepared:

Balance Sheet:

  • Cost Principle: Assets recorded at cost
  • Economic Entity: Only business assets/liabilities included
  • Going Concern: Assets not at liquidation value

Income Statement:

  • Revenue Recognition: Revenue when earned
  • Matching Principle: Expenses matched with revenues
  • Time Period: Covers specific period

All Statements:

  • Full Disclosure: Notes provide additional information
  • Monetary Unit: All amounts in euros
  • Accrual Basis: Transactions when they occur

Luxembourg Compliance Note​

Luxembourg accounting standards (PCN) incorporate these principles. All financial statements filed with RCS must:

  • Follow cost principle for assets
  • Use accrual basis accounting
  • Apply matching principle
  • Include full disclosure in notes
  • Assume going concern
  • Use euros as monetary unit

Think It Through​

Marie's restaurant receives a €1,000 advance payment in November for a catering event in December. According to the revenue recognition principle, when should this revenue be recorded? Why?

Concepts in Practice​

Luxembourg VAT and Accrual Accounting:

When a Luxembourg business makes a sale:

  • Revenue is recorded when the sale occurs (accrual basis)
  • VAT is recorded as VAT Payable (430000) at the same time
  • Cash receipt timing is separate from revenue recognition

This ensures accurate VAT reporting and compliance with eCDF filing requirements.