Accounting Concepts are the basic propositions and fundamental assumptions on which accounting operates. Financial statements are prepared and transactions are recorded on the basis of these generally accepted rules of accountancy. By following accounting concepts we can ensure that the users of such financial statements are better able to understand and compare the financial statements.
After going through this lesson, you shall be able to understand the following Principles & Concepts of Accounting.
- Business Entity Concept
- Money Measurement Concept
- Prudence or Conservatism Concept
- Dual Aspect or Duality
- Matching Concept
- Historical Cost Concept
- Accounting Period Concept
- Full Disclosure Principle
- Materiality Concept
- Objectivity Concept
- Revenue Recognition or Realisation Concept
Accounting Concepts #1
Business Entity Concept
According to the business entity concept, a business may be a separate entity from its owners. This basically means personal transactions of the owners of the business are to be treated separately from the business transactions. While preparing accounts of any sort of organization be it Sole Proprietorship, Partnership, Company, etc. we have to always treat the private transactions of the owner as a break away from the business transactions.
Examples
Mr. A, a lawyer has 5 rooms in his house, which he has rented for Rs 50,000 per month. He decided to start his own practice for which he decided to use one of the rooms. consistent with the business entity concept, only 1/5th of the rent i.e. Rs 10,000 should be charged to business, as the other 4 rooms are used for personal purposes.
Mr. A has got to pay membership fees of Rs 1,000 per month to the Bar Council of India; he paid the same through his personal account. In such a situation an equivalent has to be considered as his additional capital.
Mr. A received a phone bill of Rs 2,500. The full amount was paid through his business account. Rs 2,000 are considered as drawings as only Rs 500 (1/5th) is related to his business and the remaining Rs 2,000 is for his personal reasons.
Accounting Concepts #2
Money Measurement Concept
According to the money measurement concept, only the transactions that are measurable in money terms are to be recorded in the books of accounts of the business. On the other hand, those transactions that are not measurable in monetary terms are to be left out of record. There are two inherent limitations in this concept which are:
Limitations in Money Measurement Concept:
Items that cannot be expressed in terms of money cannot be recorded as accounting transactions. For example, employee skill level, working conditions, loyalty of customers, employee morale etc.
Money is assumed to have static value across the years but this doesn’t hold good as the value of money keeps on changing day-by-day.
Accounting Concepts #3
Prudence or Conservatism Concepts
While preparing accounting statements we make use of estimates as certain accounting data could be uncertain but it’s important to disclose an equivalent so as to present a real and fair view of the actual position of the business. While making such estimates an accountant has got to be prudent or must have a conservative outlook regarding an equivalent . The concept of Prudence states that “One shall not anticipate profit but shall always provide for all prospective losses”. This makes sure that the assets and incomes aren’t overstated, while liabilities and losses aren’t understated.
Examples
Bad debts are sure to occur in any sort of business. Due to the principle of prudence, we make provision for bad debts which helps a business show its current position.
The worth of assets is checked from time to time to form sure that their book value is not much different than their actual market value. In the case of fixed assets, if the actual market value is very low then the assets have to be impaired.
Accounting Concepts #4
Dual Aspect or Duality Concepts
The dual Aspect concept states that every financial transaction has twofold effects. These two aspects always have equal effects. In simple terms, we can state that for every debit there exists a credit.
Examples
For example, Mr. A started his business with an amount of Rs 1,00,000; this will result in an increase in the cash balance on the asset side by Rs 1, 00,000. Due to the operation of duality, the owner’s equity or capital will also increase by an equal amount. We can observe here that the two items that got affected are cash and capital account.
In a similar way, let’s suppose Tom bought goods worth Rs 50,000 on credit then on one hand his assets will increase by Rs 50,000 while on the other hand, his liabilities will also increase by Rs 50,000.
Hence the duality principle can be expressed in terms of fundamental Accounting Equation which can be written as follows: Assets = Liabilities + Capital
Accounting Concepts #5
Matching Principle Concept
According to the matching principle, the expenses which are incurred to earn revenue shall be recorded within the same accounting period during which such revenue is recognized and not within the next or previous accounting period.
Examples
Sales worth Rs 5,00,000 is formed in 2012. Total Inventory worth Rs 2,50,000 was purchased, of which Rs 50,000 remained in hand at the top of 2012. Rs 2,00,000 [i.e. Rs 2,50,000 minus Rs 50,000] is the cost of earning revenue worth Rs 5,00,000 and this 2,00,000 shall be recorded in 2012 resulting in gross profit of Rs 3,00,000.
A Law Firm pays Rs 50,000 per month as salary to each of the 4 lawyers employed by it. Rs 2,00,000 worth of monthly salaries must be matched with the revenue generated say Rs 4,00,000.
Accounting Concepts #6
Historical Cost Concept
The basic objective of the preparation of monetary statements is to enable comparability of monetary data and consistency in the adoption of financial policies. In order to realize the above objectives, the transactions shall be recorded on historical cost. In the case in the subsequent period, there is a rise within the value of the assets then an equivalent shall not be recorded within the books of accounts.
Examples
In May 2013, 1000 units of inventory were purchased by Mr. X for Rs 10 per unit, in June 2013 the worth of Inventory rose to Rs 12 per unit. According to the historical cost concept, the inventory shall appear at Rs 10,000, not at Rs 12,000.
XYZ Ltd. developed ERP software at a cost of Rs 25,00,000, while the benefit that can be derived out of an equivalent is Rs 75,00,000. In such a situation, we will recognize Rs 25,00,000 within the record because of the cost of ERP and not Rs 75,00,000.
Accounting Concepts #7
Accounting Period Concept
Even though a business is assumed to continue forever (going concern assumption) but it is necessary to keep accounts in such a way that the results are known at frequent intervals. This time interval is known as the “Accounting Period”.
While accounting periods might vary in terms of reporting dates but they must be consistent. The various users of accounting information require financial information at regular intervals, so we cannot wait for the liquidation of the company for the preparation of financial statements. Hence, as per the accounting period concept, the financial statements are prepared at regular intervals of time.
Examples
XYZ Ltd. refused to prepare books of accounts for the year ended 31 March 2013 saying that according to the concept of going concerned its business is never ending entity and it shall go on forever so it shall not prepare the accounts. But, Mr. B clarified this doubt of XYZ Ltd. by quoting the Accounting Period Concept, thus XYZ Ltd. has to prepare its books of accounts for the year ending 31 March 2013.
Accounting Concepts #8
Full Disclosure Principle
According to the principle of full disclosure, the financial statements shall disclose all material facts either on the face of it or within the notes to accounts. The full disclosure principle is of great relevance to the materiality concept. Even though the provisions of the Companies Act, 1956 has made many disclosures mandatory for the businesses but still there are several ways in which the businesses can make better disclosure.
Examples
A business shall disclose all its accounting policies so as to assist the users of financial statements to better understand the financial reports.
Contingent liabilities, contingent assets, and other legal obligations, etc. must be disclosed within the financial statements in order that it helps the users to form an informed choice.
Events that have occurred after the preparation of financial statements but before the issue of financial statements are to be disclosed in the financial statements.
ABC Ltd sold one of its subsidiaries G Ltd to Mrs. A (director Mr. A’s wife), then such information should be disclosed within the financial statements.
Accounting Concepts #9
Materiality Concept
The main aim of the preparation of monetary statements is to enable the top users of the financial statements in making informed decisions. Thus, all such information which has the ability to affect the top user’s decisions is material in nature and must be disclosed in the financial statements.
The decision of whether information has relevance or not involves a component of judgment. This depends on two factors i.e. the amount involved or the importance of the event.
Examples
XYZ Ltd Company is involved in the exploration of gold mines in Zambia, the government of Zambia has passed replacement legislation that will place a ban on the export of gold from the country which will seriously jeopardize the longer-term prospects of the company. In such a case, this being material information shall be disclosed in the financial statements of XYZ Ltd.
The remuneration paid to the administrators and key employees shall be disclosed in the financial statements as this is a material figure for various stakeholders.
the varied accounting policies employed by organizations must be disclosed in the financial statements in order to enable a better understanding of the financial position of the company.
Accounting Concepts #10
Objectivity Principle Concept
According to the objectivity principle, accounting should be free from personal bias. That is, the accounting transaction should be supported with written documents such as cash memo, invoices etc. It basically means that the accounting entries shall be based on facts rather than being open to interpretation, as interpretations are nothing but opinions.
Examples
Mr. X bought a plot of land 5 years ago for Rs 20,00,000. Today, he gets the valuation of plot done from 5 different valuators who all are experts in their field. But, at the end of the day they are giving an opinion only on the value of land
which is subjective. The only thing objective here is the value of land 5 Years ago i.e. Rs 20, 00,000 and the same should be taken into consideration.
Miss A is an accountant responsible for auditing the accounts of XYZ Ltd. She asks for invoices and other documents to support the purchases and sales. XYZ Ltd requests her to take the numbers as given as it will involve too much work for them to search for related documents. Subsequently, she took the totals as given violating the objectivity principle because financial statements must be based on verifiable and reliable documents and not on someone’s opinion or interpretation.
Accounting Concepts #11
Revenue Recognition or Realisation Concept
According to the concept of revenue recognition, revenue is to be recognized only when rewards and benefits are associated with the items sold and services provided are transferred i.e. when the right to receive money is established. In other words, at the point where the seller has completed his part of the transaction. It is to be noted that receipt of revenue and receipt of an amount are two distinct aspects.
Examples
When Vodafone sells you the talk time through scratch cards, it does not recognize the revenue when the scratch card is sold, but it is recognized when the subscriber makes a call and consumes talk time.
India Today Receives an annual subscription of Rs 240 from Mr. X during the beginning of the year but it recognizes revenue worth Rs 20 (i.e. Rs 240/12) each month.
Star Sports recognizes the revenue when the advertisement is actually aired. That is, it does not matter whether the payment is received in advance or after the broadcast of the advertisement
Also, Read Accounting Principles