5 Accounting Concepts

Deepika Gautam

QUADRANT I

1.   Module-5 : ACCOUNTING CONCEPTS

2.      Learning objectives

3.      Introduction

4.      Accounting Concept: Meaning

5.      Business Entity Concept

6.      Money Measurement Concept

7.      Going Concern Concept

8.      Cost Concept

9.      Dual Aspect Concept

10.  Accounting period Concept

11.  Matching Concept

12.  Realization Concept

13.  Objective Evidence Concept

14.  Accrual Concept

15.  Summary

LEARNING OBJECTIVES:

This module helps to understand the meaning of accounting concepts and its various types. After going through the module, students will be able to list down various concepts and also explain them in detail.

INTRODUCTION:

The main aim of a business is to earn profits. For earning profits, businessman will need to deal with the outside world and make efforts to attract more investors. For this purpose, every business maintains a record of all the transactions taking place throughout the year so that at the end of the year, information regarding the financial strength of the firm is disclosed to its owners as well as to the interested parties. And the information so disclosed should be free from any kind of biasness and should be easily understood by every party. In order to maintain this level of consistency the accountants follow certain rules and procedures while maintaining the record, known as accounting concepts and conventions. Following these concepts and conventions would maintain stability and uniformity in the accounting world.

ACCOUNTING CONCEPT: MEANING

The term concept also known as postulates refer to such ideas which are accompanied with different accounting procedures. These are the fundamental ideas or the general assumptions underlying the theory and practice of financial accounting and are broad working rules for all accounting activities and developed by the accounting profession. The important concepts are listed below:

1)      Business Entity Concept

2)      Money Measurement Concept

3)      Going Concern Concept

4)      Cost Concept

5)      Dual Aspect Concept

6)      Accounting Period

7)      Matching Concept

8)      Realization Concept

9)      Objective Evidence Concept

10)  Accrual Concept

BUSINESS ENTITY CONCEPT

The concept implies that a business unit is separate and distinct from the persons who supply capital to it (owners). Means that business has a separate legal entity from its owners. For the purpose of accounting the business and its owners are to be treated as two separate entities. Irrespective of the form of organisation, a business unit has got its own separate identity as distinguished from the persons who own or control it(owners). Business is kept separate from the proprietor so that transactions of the business may not be recorded with him. In case this concept is not followed, affairs of the business will be mixed up with the private affairs of the proprietor and the true picture of the business will not be revealed. Thus, in the books of the sole trader, a firm or a limited company, only business transactions are recorded and no note is taken of the personal transactions of the sole proprietor, the partners of the firm and the shareholders respectively.

For Example: if the proprietor of the business invests Rs 600000 into the business, it will be deemed that he has given that much of money to the business as a loan which will be shown as a liability in the books of the firm. On receipt of the amount, cash account will be debited and the proprietor’s capital account will be credited. Similarly, on withdrawal of the amount from the business for personal use of the proprietor, the proprietor’s capital account will be debited and Cash account will be credited.

MONEY MEASUREMENT CONCEPT

The concept of money measurement states that only those transactions, events and happenings in the organisation which can be expressed in terms of money (such as sale of goods, receipt of income etc) are to be recorded in the book of accounts. All those transactions that cannot be expressed in monetary terms (such as appointment of the manager, creativity of its production department) should not be recorded. The advantage of maintaining business transactions in terms of money is that money serves a common denominator by means of which homogenous factors about a business can be expressed in terms of numbers (money), which are capable of additions and subtractions in future.

For Example: The business unit has the following assets as on March 31,2015

Cash in hand and Bank:  Rs 50000

Sundry Debtors :	Rs 45000
Furniture :	400 tables
Bills Receivable:	Rs 16500

In the above example furniture is not expressed in terms of money, therefore the items given in the different units of measurement cannot be added together to get an idea of the total value of the assets owned by the enterprise, to get an idea of the total value of the assets, all items should be expressed in terms of money as given below:

Cash in hand and Bank: Rs 50000

Sundry Debtors :	Rs 45000
Furniture :		Rs 15000
Bills Receivable:	Rs 16500
TOTAL	:	Rs 126500

The money measurement concept faces certain limitations:

(1)   It restricts the scope of accounting because it is not capable of recording transactions which cannot be expressed in terms of money, though being important.

(2)   It does not take care of the effects of inflation because it assumes a stability of money measurement unit.

GOING CONCERN CONCEPT

The concept of going concern assumes that a business firm would continue to carry out its operations indefinitely, i.e., for a fairly long period of time and would not be liquidated or terminated in the foreseeable future. This is an important assumption of accounting as it provides the very basis for showing the value of assets in the balance sheet.

A business unit is deemed to be a going concern and not a gone concern. This assumption provides much of the justification of recording fixed assets at original cost and depreciating them in a systematic manner year after year without reference to their current realisable value.

For Example: A business purchases machinery for a sum of Rs 40,000. What the business is buying really is the services of the machinery that the business shall be getting over the estimated life span, say 10 years. It will not be fair to charge the whole amount of Rs 40,000 from the revenue of the year in which the asset is purchased. The assumption regarding the continuity of the business, allows to charge from the revenue of a period only that part of the asset that has been consumed or used to earn that revenue in that period, and carry forward the remaining amount to the next years. Thus the business may charge Rs 4000 every year for 10 years from the profit and loss account. In case, the continuity assumption is not there, the whole cost (Rs 40,000 in the present example) will need to be charged from the revenue of the year in which the machinery was purchased.

QUICK REVISION

1)  The going concern concept states that a business enterprise will not be sold in the near future.

2)  The fact that business is separate from its owner is best exemplified by the business entity concept.

COST CONCEPT

The cost concept states that, an asset is recorded in the books at the price paid to acquire it and that this cost is the basis for all subsequent accounting for that asset. This does not mean that the asset will always be shown at cost, but it means that the acquiring cost becomes basis for all future accounting for the asset. Asset is recorded at cost at the time of its purchase but is reduced systematically in its value by charging depreciation by following any of the method.

In simple terms, the market value of an asset may change with the passage of time but for accounting purposes it continues to be shown in the books at its book value, i.e., the cost at which it was purchased minus Depreciation provided up to date. In the absence of cost concept, assets will be shown at their market values which will depend on the subjective views of persons who furnish financial statements, hence consistency will be hampered.

For Example: A machine was purchased by Goel Limited for Rs 800000, for manufacturing shoes. Amount of Rs 10000 was spent on transporting it. In addition Rs 12000 was spent on its instalment. The total amount at which the machinery will be recorded in the books would be sum of all three items i.e. Rs 822000. This is also known as historical cost. Now suppose, the market price of the same is now Rs 90000 it will not be shown at this value. Further, it should be made clear that cost means original or acquisition cost only for new assets and for the old ones, cost means original cost less depreciation.

DUAL ASPECT CONCEPT

It is the foundation or main principle of accounting. It provides the very basis of recording business transactions in the books of accounts. This concept assumes that every transaction has a dual effect (a) yielding of a benefit (b) the giving of that benefit. This means it affects two accounts in their respective opposite sides (Debit or Credit). Therefore the transaction should be recorded at two places. It means, both aspects of the transaction should be recorded, debit or credit.

For Example: if the business has acquired an asset, it must have given up some other asset (such as cash). There must be a dual entry to have a complete record of each business transaction, an entry should be passed in the receiving account and an entry of the same amount in the giving account. The receiving account is termed as debtor and the giving account is called creditor. Thus every debit must have a corresponding credit and vice versa, with the same amount.

Thus, the dual concept is commonly expressed in terms of fundamental accounting equation:

Assets= Liabilities+ Capital

The above accounting equation states that the assets of a business are always equal to the claims of owner/owners or outsiders.

ACCOUNTING PERIOD CONCEPT

All the transactions are recorded in the books of accounts on the assumption that profits on these transactions are to be ascertained for a specified period. This is known as accounting period concept. Accounting period refers to the period of time at the end of which the financial statements of an enterprise are prepared to know whether it has earned profits or incurred losses during that period and what exactly is the position of its assets and liabilities at the end of that particular period. Thus, this concept requires that the balance sheet and profit and loss account should be prepared at regular intervals. This is necessary for different purposes like, calculation of profits, ascertaining financial position, tax computation etc.

Further this concept assumes that, indefinite life of business is divided into small parts. These parts are known as accounting periods. It may be of one year, six months, three months or one month. But mostly, one year is taken as one accounting period which may be a calendar or financial year.

CALENDER YEAR: Year which starts from January1st and ends on December 31st FINANCIAL YEAR: Year which starts from April 1st and ends on March 31st

In India business enterprises usually follow Financial Year to prepare their accounts

As per accounting period concept, all the transactions are recorded in the books of accounts for that specific period of time. Hence goods purchased and sold during 2013, rent, salaries etc. paid for 2013 are accounted for and against that period only (2013).

MATCHING CONCEPT

This concept is based on the accounting period concept. The most important objective of running a business is to ascertain profit periodically. The determination of profit of a particular accounting period is essentially a process of matching the revenue recognised during that period and the costs to be allocated to the period to obtain the revenue. It is, thus a concept of matching revenues and expected costs, the residual amount being the net profit or net loss for the period.

For Example: Let us study the following transactions of a business during the month of December, 2013

(i)  Sale: cash Rs.12000 and credit Rs.11000

(ii)  Salaries Paid Rs.20000

(iii)	Commission	Paid	Rs.11500
(iv)	Interest	Received	Rs.5000
(v)   Rent	received   Rs.1140,   out	of   which   Rs.140   received   for   the	year   2012
(vi)	Carriage	paid	Rs.200

(vii)  Postage Rs.300

(viii)  Rent paid Rs.1200, out of which Rs.50 belong to the year 2011

    (ix)  Goods purchased in the year for cash Rs.11500 and on credit Rs.5000

(x)  Depreciation on machine Rs.2000

Let us record the above transactions under the heading of Expenses and Revenue

In the above example expenses have been matched with revenue i.e., (Revenue Rs.29000-Expenses Rs.51650). This comparison has resulted in loss of Rs.22650. If the revenue is more than the expenses, it is called profit.

If the expenses are more than revenue it is called loss. This is what exactly has been done by applying the matching concept. Therefore, the matching concept implies that all revenues earned during an accounting year, whether received/not received during that year and all cost incurred, whether paid/not paid during the year should be taken into account while ascertaining profit or loss for that year.

QUICK REVISION

(i)    Expenses are matched with revenue generated during a period.

(ii)    Goods sold for cash is an example of revenue

(iii)    Matching concept states that the revenue and the expenses incurred to earn the brevenue must belong to the same accounting period

(iv)        The cost concept states that all fixed assets are recorded in the books of accounts at their purchase price.

REALIZATION CONCEPT

This concept states that revenue from any business transaction should be included in the accounting records only when it is realised. The term realisation means creation of legal right to receive money. Selling goods is realisation, receiving order is not.

In other words, it can be said that: Revenue is said to have been realised when cash has been received or right to receive cash on the sale of goods or services or both has been created. Let us study the following examples:

(i)    Sheel Jeweller received an order to supply gold ornaments worth Rs.1800000. They supplied ornaments worth Rs.1600000 up to the year ending 31st December 2013 and rest of the ornaments were supplied in January 2013.

(ii)  Mr. Ram sold goods for Rs.400000 for cash in 2014 and the goods have been delivered during the same year.

(iii)   Akshay and Sons Ltd sold goods on credit for Rs.50,000 during the year ending 31st December 2013. The goods have been delivered in 2013 but the payment was received in March 2014.

Now, let us analyse the above examples to ascertain the correct amount of revenue realised for the year ending 31st December 2013.

(i)   The revenue for the year 2013 for Sheel Jeweller is Rs.1600000. Mere getting an order is not considered as revenue until the goods have been delivered.

(ii)  The revenue for Mr. Ram for year 2013 is Rs.400000 as the goods have been delivered in the year 2013. Cash has also been received in the same year.

(iii)   Akshay & Sons Ltd’s revenue for the year 2013 is Rs.50,000, because the goods have been delivered to the customer in the year 2013. Revenue became due in the year 2013 itself. In the above examples, revenue is realised when the goods are delivered to the customers. The concept of realisation states that revenue is realized at the time when goods or services are actually delivered.

OBJECTIVE EVIDENCE CONCEPT

Objectivity connotes reliability, trustworthiness and verifiability, which means that there is some evidence in ascertaining the correctness of the information reported. Entries in the accounting records and data reported in financial statements must be based on objectively determined evidence or proof. Without close adherence to this principle, the confidence of many users of the financial statements could not be maintained. Invoices and vouchers for purchases and sales, bank statements for amount of cash at bank, physical checking of stock in hand etc are examples of objective evidence which are capable of verification. In simple terms, this concept means that accounting transactions should be recorded in an objective manner, free from biasness of accountants. This can be possible when each transaction is supported by verifiable documents or vouchers, that serve as a proof to those studying the accounts.  Only those transactions that are supported by physical evidence, can be recorded in the books of accounts

For Example: the transaction for the purchase of machinery by ABC Ltd. may be supported by the cash receipt for the money paid, if the same is purchased on cash. Or copy of invoice and delivery challan if the same is purchased on credit. Similarly, receipt for the amount paid for purchase of machine becomes the documentary evidence (proof) for the cost of machinery and provides an objective basis for verifying this transaction.

ACCRUAL CONCEPT

The essence of the accrual concept is that revenue is recognised when it is realised, that is when sale is complete or services are given and it is considered immaterial whether cash is received or not. Similarly, according to this concept, expenses are recognised in the same accounting period in which they help in earning the revenue whether cash is paid or not. An exception to this general rule is the preparation of cash flow statement whose main purpose is to present the cash flow effects of transaction during an accounting period. Thus to ascertain correct financial position of the enterprise for an accounting period, we make record of all expenses and incomes relating to the accounting period whether actual cash has been paid or received or not. Therefore, as a result of the accrual concept, outstanding expenses and incomes are taken into consideration while preparing final accounts of a business entity.

SUMMARY

Accounting is the business language, by which its financial position is communicated to audience. And to make sure that communication is done properly, accounting concepts are framed. Accounting concept refers to the basic assumptions which serve the basis of recording actual business transactions.

The important accounting concepts are business entity, money measurement, going concern, accounting period, cost concept, dual aspect concept, realisation concept, accrual concept, objective evidence and matching concept. Business entity concept assumes that for accounting purposes, the business enterprise and its owner(s) are two separate entities. Money measurement concept assumes that all business transactions must be recorded in the books of accounts in terms of money. Going concern concept states that a business firm will continue to carry on activities for an indefinite period of time. Accounting period concept states that all the business transactions are recorded in the books of accounts on the assumption that profits of transactions is to be ascertained for a specified time period. Accounting cost concept states that all assets are recorded in the books of accounts at their cost price. Dual aspect concept states that every transaction has a dual effect. Whereas, Objective Evidence concept states that only those entries should be recorded in the books of accounts which are supported by some physical evidence like invoice or voucher.

Few suggested readings to learn more:

1)      Ashis Bhattacharya “Financial Accounting” Prentice hall of India Pvt. Ltd, New Delhi.

2)      B.B Dam & HC Gautam “Theory and Practice of Financial Accounting” Capital PublishingCompany, Guwahati.

3)      Jain & Narang “Accounting Theory and Management Accounting” Kalyani Publishers.

4)      R.L. Gupta & M. Radhaswamy “ Advance Accountancy” Sultan Chand & Sons, New Delhi.

5)      S.N. Maheshwari “Financial Accounting” Vikas Publishing House Pvt. Ltd., New Delhi.

Points to ponder

1)      Accounting is the business language, by which its financial position is communicated to audience.

2)      And to make sure that communication is done properly, accounting concepts are framed.

3)      Accounting concept refers to the basic assumptions which serve the basis of recording actual business transactions.

4)      The important accounting concepts are business entity, money measurement, going concern, accounting period, cost concept, dual aspect concept, realisation concept, accrual concept, objective evidence and matching concept.

5)      Business entity concept assumes that for accounting purposes, the business enterprise and its owner(s) are two separate entities.

6)      Money measurement concept assumes that all business transactions must be recorded in the books of accounts in terms of money.

• 7) Going concern concept states that a business firm will continue to carry on activities for an indefinite period of time and will not dissolve.
• 8) Accounting period concept states that all the business transactions are recorded in the books of accounts on the assumption that profits of transactions is to be ascertained for a specified time period.
• 9) Accounting cost concept states that all assets are recorded in the books of accounts at their cost price.
• 10) Dual aspect concept states that every transaction has a dual effect.
• 11) Objective Evidence concept states that only those entries should be recorded in the books of accounts which are supported by some physical evidence like invoice or voucher.