Introduction
Accounting concept refers to the basic assumptions and rules and
principles which work as the basis of recording of business transactions
and preparing accounts. The main objective is to maintain uniformity and consistency in accounting
records. These concepts constitute the very basis of accounting. All the
concepts have been developed over the years from experience and thus they
are universally accepted rules.
Following are the various accounting
concepts that have been discussed in the following sections :
Business Entity Concepts
It is generally accepted that the moment a business
enterprise is started it attains a separate entity as distinct from the persons
who own it. In recording the transactions of a business, the important question
is:
How do these transactions affect the business enterprise?
The question as to how these transactions affect the proprietors is quite
irrelevant. This concept is extremely useful in keeping business affairs
strictly free from the effect of private affairs of the proprietors. In the
absence of this concept the private affairs and business affairs are mingled
together in such a way that the true profit or loss of the business enterprise
cannot be ascertained nor its financial position. To quote an example, if a
proprietor has taken rs.5000/- from the business for paying house tax for his
residence, the amount should be deducted from the capital contributed by him.
Instead if it is added to the other business expenses then the profit will be
reduced by rs.5000/- and also his capital more by the same amount. This affects
the results of the business and also its financial position. Not only this,
since the profit is lowered, the consequential tax payment also will be less
which is against the provisions of the income-tax act.
Significance
The following points highlight the significance of business entity concept :
- This concept helps in ascertaining the profit of the business as only the business expenses and revenues are recorded and all the private and personal expenses are ignored.
- This concept restraints accountants from recording of owner’s private/personal transactions.
- It also facilitates the recording and reporting of business transactions from the business point of view
- It is the very basis of accounting concepts, conventions and principles.
Going Concern Concept:
This concept assumes that the business enterprise will
continue to operate for a fairly long period in the future. The significance of
this concept is that the accountant while valuing the assets of the enterprise
does not take into account their current resale values as there is no immediate
expectation of selling it. Moreover, depreciation on fixed assets is charged on
the basis of their expected life rather than on their market values. When there
is conclusive evidence that the business enterprise has a limited life, the
accounting procedures should be appropriate to the expected terminal date of
the enterprise. In such cases, the financial statements could clearly disclose
the limited life of the enterprise and should be prepared from the ‘quitting
concern’ point of view rather than from a ‘going concern’ point of view.
Significance
The following points highlight the significance of going concern concept;
This concept facilitates preparation of financial statements.
- On the basis of this concept, depreciation is charged on the fixed asset.
- It is of great help to the investors, because, it assures them that they will continue to get income on their investments.
- In the absence of this concept, the cost of a fixed asset will be treated as an expense in the year of its purchase.
- A business is judged for its capacity to earn profits in future.
Money Measurement Concept:
Accounting records only those transactions which can be
expressed in monetary terms. This feature is well emphasised in the two definitions
on accounting as given by the american institute of certified public
accountants and the american accounting principles board. The importance of
this concept is that money provides a common denomination by means of which
heterogeneous facts about a business enterprise can be expressed and measured
in a much better way. For e.g. When it is stated that a business owns
rs.1,00,000 cash, 500 tons of raw material, 10 machinery items, 3000 square
meters of land and building etc., these amounts cannot be added together to
produce a meaningful total of what the business owns. However, by expressing
these items in monetary terms such as rs.1,00,000 cash, rs.5,00,000 worth raw
materials, rs,10,00,000 worth machinery items and rs.30,00,000 worth land and
building – such an addition is possible.
A serious limitation of this concept is that accounting does
not take into account pertinent non-monetary items which may significantly
affect the enterprise. For instance, accounting does not give information about
the poor health of the chairman, serious misunderstanding between the
production and sales manager etc., which have serious bearing on the prospects
of the enterprise. Another limitation of this concept is that money is
expressed in terms of its value at the time a transaction is recorded in the
accounts. Subsequent changes in the purchasing power of money are not taken
into account.
The following points highlight the significance of money measurement concept :
- It helps in recording business transactions uniformly.
- If all the business transactions are expressed in monetary terms, it will be easy to understand the accounts prepared by the business enterprise.
- It facilitates comparison of business performance of two different periods of the same firm or of the two different firms for the same period.
Cost Concept:
This concept is yet another fundamental concept of
accounting which is closely related to the going-concern concept. As per this
concept: (i) an asset is ordinarily entered in the accounting records at the
price paid to acquire it i.e., at its cost and (ii) this cost is the basis for
all subsequent accounting for the asset.
The implication of this concept is that the purchase of an
asset is recorded in the books at the price actually paid for it irrespective
of its market value. For e.g. If a business buys a building for rs.3,00,000,
the asset would be recorded in the books as rs.3,00,000 even if its market
value at that time happens to be rs.4,00,000. However, this concept does not
mean that the asset will always be shown at cost. This cost becomes the basis
for all future accounting of the asset. It means that the asset may
systematically be reduced in its value by changing depreciation. The
significant advantage of this concept is that it brings in objectivity in the
preparations and presentation of financial statements. But like the money
measurement concept, this concept also does not take into account subsequent
changes in the purchasing power of money due to inflationary pressures. This is
the reason for the growing importance of inflation accounting.
Significance
- This concept requires asset to be shown at the price it has been acquired, which can be verified from the supporting documents.
- It helps in calculating depreciation on fixed assets.
- The effect of cost concept is that if the business entity does not pay anything for an asset, this item will not be shown in the books of accounts.
Dual Aspect Concept (Double Entry System):
This concept is the core of accounting. According to this
concept every business transaction has a dual aspect. This concept is explained
in detail below:
The properties owned by a business enterprise are referred
to as assets and the rights or claims to the various parties against the assets
are referred to as equities. The relationship between the two may be expressed
in the form of an equation as follows:
Equities = Assets
Equities may be subdivided into two principal types: the
rights of creditors and the rights of owners. The rights of creditors represent
debts of the business and are called liabilities. The rights of the owners are
called capital.
Expansion of the equation to give recognition to the two
types of equities results in the following which is known as the accounting
equation:
Liabilities + Capital = Assets
It is customary to place ‘liabilities’ before ‘capital’
because creditors have priority in the repayment of their claims as compared to
that of owners. Sometimes greater emphasis is given to the residual claim of
the owners by transferring liabilities to the other side of the equation as:
Capital = Assets – Liabilities
All business transactions, however simple or complex they
are, result in a change in the three basic elements of the equation. This is
well explained with the help of the following series of examples:
(i) Mr. Prasad commenced business with a capital of
rs.3,000: the result of this transaction is that the business, being a separate
entity, gets cash-asset of rs.30,000 and has to pay to Mr. Prasad rs.30,000,
his capital. This transaction can be expressed in the form of the equation as
follows:
Capital = Assets
Prasad Cash
30,000 30,000
(ii) purchased furniture for rs.5,000: the effect of this
transaction is that cash is reduced by rs.5,000 and a new asset viz. Furniture
worth rs.5,000 comes in, thereby, rendering no change in the total assets of
the business. The equation after this transaction will be:
Capital = Assets
Prasad Cash + Furniture
30,000 25,000 + 5,000
(iii) borrowed rs.20,000 from Mr. Gopal: as a result of this
transaction both the sides of the equation increase by rs.20,000; cash balance
is increased and a liability to Mr. Gopal is created. The equation will appear
as follows:
Liabilities + Capital = Assets
Creditors + Prasad Cash + Furniture
20,000 30,000 45,000 5,000
(iv) purchased goods for cash rs.30,000: this transaction
does not affect the liabilities side total nor the asset side total. Only the
composition of the total assets changes i.e. Cash is reduced by rs.30,000 and a
new asset viz. Stock worth rs.30,000 comes in. The equation after this
transaction will be as follows:
Liabilities + Capital =Asset
Creditors Prasad Cash + Stock + Furniture
20,000 30,000 15,000 30,000 5,000
(v) goods worth rs.10,000 are sold on credit to Ganesh for
rs.12,000. The result is that stock is reduced by rs.10,000 a new asset namely
debtor (Mr. Ganesh) for rs.12,000 comes into picture and the capital of Mr. Prasad increases by rs.2,000 as the profit on the sale of goods belongs to the
owner. Now the accounting equation will look as under:
Liabilities + Capital = Asset
Creditors Prasad Cash + Debtors + Stock + Furniture
20,000 32,000 15,000 12,000 20,000 5,000
(vi) paid electricity charges rs.300: this transaction
reduces both the cash balance and mr. Prasad’s capital by rs.300. This is so
because the expenditure reduces the business profit which in turn reduces the
equity.
The equation after this will be:
Liabilities + Capital =Assets
Creditors + Prasad Cash + Debtors + Stock + Furniture
20,000 31,700 14,700 12,000 20,000 5,000
Thus it may be seen that whatever is the nature of
transaction, the accounting equation always tallies and should tally. The
system of recording transactions based on this concept is called double entry
system.
Accounting Period Concept:
In accordance with the going concern concept it is usually
assumed that the life of a business is indefinitely long. But owners and other
interested parties cannot wait until the business has been wound up for
obtaining information about its results and financial position. For e.g. If for
ten years no accounts have been prepared and if the business has been
consistently incurring losses, there may not be any capital at all at the end
of the tenth year which will be known only at that time. This would result in
the compulsory winding up of the business. But, if at frequent intervals
information are made available as to how things are going, then corrective
measures may be suggested and remedial action may be taken. That is why,
pacioli wrote as early as in 1494: ‘frequent accounting makes for only
friendship’. This need leads to the accounting period concept.
According to this concept accounting measures activities for
a specified interval of time called the accounting period. For the purpose of
reporting to various interested parties one year is the usual accounting
period. Though pacioli wrote that books should be closed each year especially
in a partnership, it applies to all types of business organisations.
Periodic Matching Of Costs And Revenues:
This concept is based on the accounting period concept. It
is widely accepted that desire of making profit is the most important
motivation to keep the proprietors engaged in business activities. Hence a
major share of attention of the accountant is being devoted towards evolving
appropriate techniques of measuring profits. One such technique is periodic
matching of costs and revenues.
In order to ascertain the profits made by the business
during a period, the accountant should match the revenues of the period with
the costs of that period. By ‘matching’ we mean appropriate association of
related revenues and expenses pertaining to a particular accounting period. To
put it in other words, profits made by a business in a particular accounting
period can be ascertained only when the revenues earned during that period are
compared with the expenses incurred for earning that revenue. The question as
to when the payment was actually received or made is irrelevant. For e.g. In a
business enterprise which adopts calendar year as accounting year, if rent for
December 1989 was paid in January 1990, the rent so paid should be taken as the
expenditure of the year 1989, revenues of that year should be matched with the
costs incurred for earning that revenue including the rent for December 1989,
though paid in January 1990. It is on account of this concept that adjustments
are made for outstanding expenses, accrued incomes, prepaid expenses etc. While
preparing financial statements at the end of the accounting period.
The system of accounting which follows this concept is
called as mercantile system. In contrast to this there is another system of
accounting called as cash system of accounting where entries are made only when
cash is received or paid, no entry being made when a payment or receipt is
merely due.
Realization Concept:
Realization refers to inflows of cash or claims to cash like
bills receivables, debtors etc. Arising from the sale of assets or rendering of
services. According to realisation concept, revenues are usually recognised in
the period in which goods were sold to customers or in which services were
rendered. Sale is considered to be made at the point when the property in goods
passes to the buyer and he becomes legally liable to pay. To illustrate this
point, let us consider the case of a, a manufacturer who produces goods on
receipt of orders. When an order is received from b, a starts the process of
production and delivers the goods to b when the production is complete. B makes
payment on receipt of goods. In this example, the sale will be presumed to have
been made not at the time when goods are delivered to b. A second aspect of the
realisation concept is that the amount recognised as revenue is the amount that
is reasonably certain to be realised. However, lot of reasoning has to be
applied to ascertain as to how certain ‘reasonably certain’ is … yet, one thing
is clear, that is, the amount of revenue to be recorded may be less than the
sales value of the goods sold and services rendered. For e.g. When goods are
sold at a discount, revenue is recorded not at the list price but at the amount
at which sale is made. Similarly, it is on account of this aspect of the
concept that when sales are made on credit, though entry is made for the full amount
of sales, the estimated amount of bad debts is treated as an expense and the
effect on net income is the same as if the revenue were reported as the amount
of sales minus the estimated amount of bad debts.
Convention of Conservatism:
It is a world of uncertainty. So it is always better to
pursue the policy of playing safe. This is the principle behind the convention
of conservatism. According to this convention the accountant must be very
careful while recognising increases in an enterprise’s profits rather than
recognising decreases in profits. For this the accountants have to follow the
rule, anticipate no profit, provide for all possible losses, while recording
business transactions. It is on account of this convention that the inventory
is valued at cost or market price whichever is less, i.e. When the market price
of the inventories has fallen below its cost price it is shown at market price
i.e. The possible loss is provided and when it is above the cost price it is
shown at cost price i.e. The anticipated profit is not recorded. It is for the
same reason that provision for bad and doubtful debts, provision for
fluctuation in investments, etc., are created. This concept affects principally
the current assets.
Convention Of Full Disclosure:
the emergence of joint stock company form of business
organisation resulted in the divorce between ownership and management. This
necessitated the full disclosure of accounting information about the enterprise
to the owners and various other interested parties. Thus the convention of full
disclosure became important. By this convention it is implied that accounts
must be honestly prepared and all material information must be adequately
disclosed therein. But it does not mean that all information that someone desires
are to be disclosed in the financial statements. It only implies that there
should be adequate disclosure of information which is of considerable value to
owners, investors, creditors, government, etc. In Sachar committee report
(1978), it has been emphasised that openness in company affairs is the best way
to secure responsible behaviour. It is in accordance with this convention that
companies act, banking companies regulation act, insurance act etc., have
prescribed proforma of financial statements to enable the concerned companies
to disclose sufficient information. The practice of appending notes relating to
various facts on items which do not find place in financial statements is also
in pursuance to this convention. The following are some examples:
(a) contingent liabilities appearing as a note
(b) market value of investments appearing as a note
(c) schedule of advances in case of banking companies
Convention Of Consistency:
According to this concept it is essential that accounting
procedures, practices and method should remain unchanged from one accounting
period to another. This enables comparison of performance in one accounting
period with that in the past. For e.g. If material issues are priced on the
basis of fifo method the same basis should be followed year after year.
Similarly, if depreciation is charged on fixed assets according to diminishing
balance method it should be done in subsequent year also. But consistency never
implies inflexibility as not to permit the introduction of improved techniques
of accounting. However if introduction of a new technique results in inflating
or deflating the figures of profit as compared to the previous methods, the
fact should be well disclosed in the financial statement.
Convention Of Materiality:
The implication of this convention is that accountant should
attach importance to material details and ignore insignificant ones. In the
absence of this distinction, accounting will unnecessarily be overburdened with
minute details. The question as to what is a material detail and what is not is
left to the discretion of the individual accountant. Further, an item should be
regarded as material if there is reason to believe that knowledge of it would
influence the decision of informed investor. Some examples of material
financial information are: fall in the value of stock, loss of markets due to
competition, change in the demand pattern due to change in government
regulations, etc. Examples of insignificant financial information are: rounding
of income to nearest ten for tax purposes etc. Sometimes if it is felt that an
immaterial item must be disclosed, the same may be shown as footnote or in
parenthesis according to its relative importance.
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