Assignment for you

ACCOUNTING CONCEPTS

The more important accounting concepts are briefly described as follows:

1. Separate Business Entity Concept In accounting, we make a distinction between business and the owner. All the books of accounts record day-to-day financial transactions from the viewpoint of the business rather than from that of the owner. The proprietor is considered a creditor to the extent of the capital brought in business by him. For instance, when a person invests Rs. 10 lakh into a business, it will be treated that the business has borrowed that much money from the owner and it will be shown as a ‘liability in the books of accounts of the business. Similarly, if the owner of a shop were to take cash from the cash box for meeting certain personal expenditure, the accounts would show that cash had been reduced even though it does not make any difference to the owner himself. Thus, in recording a transaction the important question is how does it affect the business? For example, if the owner puts cash into the business, he has a claim against the business for capital brought in. In so far as a limited company is concerned, this distinction can be easily maintained because a company has a legal entity like a natural person it can engage itself in economic activities of buying, selling, producing, lending, borrowing, and consuming of goods and services. However, it is difficult to show this distinction in the case of sole proprietorship and partnership. Nevertheless, accounting still maintains the separation of business and owner. It may be noted that it is only for accounting purposes that partnerships and sole proprietorship are treated as separate from the owner (s), though the law does not make such distinction. In fact, the business entity concept is applied to make it possible for the owners to assess the performance of their business and the performance of those who manage the enterprise. The managers are responsible for the proper use of funds supplied by owners, banks, and others.

2. Money Measurement Concept In accounting, only those business transactions are recorded which can be expressed in terms of money. In other words, a fact or transaction or happening which cannot be expressed in terms of money is not recorded in the accounting books. As money is accepted not only as a medium of exchange but also as a store of value, it has a very important advantage since a number of assets and equities, which are otherwise different, can be measured and expressed in terms of a common denominator. We must realise that this concept imposes two severe limitations. Firstly, there are several facts which though very important to the business, cannot be recorded in the books of accounts because they cannot be expressed in money terms. For example, general health condition of the Managing Director of the company, working conditions in which a worker has to work, sales policy pursued by the enterprise, quality of product introduced by the enterprise, though exert a great influence on the productivity and profitability of the enterprise, are not recorded in the books. Similarly, the fact that a strike is about to begin because employees are dissatisfied with the poor working conditions in the factory will not be recorded even though this event is of great concern to the business. You will agree that all these have a bearing on the future profitability of the company. Secondly, the use of money implies that we assume stable or constant value of rupee. Taking this assumption means that the changes in the money value in future dates is conveniently ignored. For example, a piece of land purchased in 1990 for Rs. 2 lakh and another bought for the same amount in 1998 are recorded at the same price, although the first purchased in 1990 may be worth two times higher than the value recorded in the books because of rising in land prices. In fact, most accountants know fully well that purchasing power of the rupee does change but very few recognize this fact in accounting books and make allowance for changing price level.

3. Dual Aspect Concept Financial accounting records all the transactions and events involving financial elements. Each of such transactions requires two aspects to be recorded. The recognition of these two aspects of every transaction is known as a dual aspect analysis. According to this concept, every business transaction has a dual effect. For example, if a firm sells goods of Rs. 5,000 this transaction involves two aspects. One aspect is the delivery of goods and the other aspect is immediate receipt of cash (in the case of cash sales). In fact, the term ‘double-entry bookkeeping has come into vogue and in this system, the total amount debited always equals the total amount credited. It follows from the ‘dual aspect concept’ that at any point of time owners’ equity and liabilities for any accounting entity will be equal to assets owned by that entity. This idea is fundamental to accounting and could be expressed as the following qualities: Assets = Liabilities + Owners Equity …(1) Owners Equity = Assets- Liabilities …(2) The above relationship is known as the ‘Accounting Equation’. The term ‘Owners Equity’ denotes the resources supplied by the owners of the entity while the term ‘liabilities’ denotes the claim of outside parties such as creditors, debenture-holders, banks against the assets of the business. Assets are the resources owned by a business. The total of assets will be equal to the total of liabilities plus owners capital because all assets of the business is claimed by either owners or outsiders.

4. Going Concern Concept Accounting assumes that the business entity will continue to operate for a long time in the future unless there is good evidence to the contrary. The enterprise is viewed as a going concern, continuing in operations, at least in the foreseeable future. In other words, there is neither the intention nor the necessity to liquidate the particular business venture in the predictable future. Because of this assumption, the accountant while valuing the assets does not take into account the forced sale value of them. In fact, the assumption that the business is not expected to be liquidated in the foreseeable future establishes the basis for many of the valuations and allocations in accounting. For example, the accountant charges depreciation on fixed assets. It is this assumption which underlies the decision of investors to commit capital to the enterprise. Only based on this assumption accounting process can remain stable and achieve the objective of correctly reporting and recording the capital invested, the efficiency of management, and the position of the enterprise as a going concern. However, if the accountant has good reasons to believe that the business or some part of it is going to be liquidated or that it will cease to operate (say within six-month or a year), then the resources could be reported at their current values. If this concept is not followed, International Accounting Standard requires the disclosure of the fact in the financial statements together with reasons.

5. Accounting Period Concept This concept requires that the life of the business should be divided into appropriate segments for studying the financial results shown by the enterprise after each segment. Although the results of operations of a specific enterprise can be known precisely only after the business has ceased to operate, its assets have been sold off and liabilities paid off, the knowledge of the results periodically is also necessary. Those who are interested in the operating results of business obviously cannot wait till the end. The requirements of these parties force the businessman ‘to stop’ and ‘see back’ how things are going on. Thus, the accountant must report for the changes in the wealth of a firm for short time periods. A year is the most common interval on account of prevailing practice, tradition, and government requirements. Some firms adopt the financial year of the government, some other calendar year. Although a twelve-month period is adopted for external reporting, a shorter span of an interval, say one month or three months is applied for internal reporting purposes. This concept poses difficulty for the process of allocation of long-term costs. All the revenues and all the costs relating to the year in operation have to be taken into account while matching the earnings and the cost of those earnings for any accounting period. This holds good irrespective of whether or not they have been received in cash or paid in cash. Despite the difficulties which stem from this concept, short-term reports are of vital importance to owners, management, creditors, and other interested parties. Hence, the accountants have no option but to resolve such difficulties.

6. Cost Concept The term ‘assets’ denotes the resources land building, machinery , etc. owned by a business. The money values that are assigned to assets are derived from the cost concept. According to this concept, an asset is ordinarily entered on the accounting records at the price paid to acquire it. For example, if a business buys a plant for Rs. 5 lakh the asset would be recorded in the books at Rs. 5 lakh, even if its market value at that time happens to be Rs. 6 lakh. Thus, assets are recorded at their original purchase price and this cost is the basis for all subsequent accounting for the business. The assets shown in the financial statements do not necessarily indicate their present market values. The term ‘book value’ is used for the amount shown in the accounting records. The cost concept does not mean that all assets remain on the accounting records at their original cost for all times to come. The asset may systematically be reduced in its value by charging ‘depreciation’, which will be discussed in detail in a subsequent lesson. Depreciation has the effect of reducing the profit of each period. The prime purpose of depreciation is to allocate the cost of an asset over its useful life and not to adjust its cost. However, a balance sheet based on this concept can be very misleading as it shows assets at a cost even when there is a wide difference between their costs and market values. Despite this limitation, you will find that the cost concept meets all the three basic norms of relevance, objectivity, and feasibility.

7. The Matching concept This concept is based on the accounting period concept. In reality we match revenues and expenses during the accounting periods. Matching is the entire process of periodic earnings measurement, often described as a process of matching expenses with revenues. In other words, income made by the enterprise during a period can be measured only when the revenue earned during a period is compared with the expenditure incurred for earning that revenue. Broadly speaking revenue is the total amount realised from the sale of goods or provision of services together with earnings from interest, dividend, and other items of income. Expenses are costs incurred in connection with the earnings of revenues. Costs incurred do not become expenses until the goods or services in question are exchanged. Cost is not synonymous with the expense since the expense is a sacrifice made, resource consumed about revenues earned during an accounting period. Only costs that have expired during an accounting period are considered expenses. For example, if a commission is paid in January 2002, for services enjoyed in November, 2001, that commission should be taken as the cost for services rendered in November 2001. On account of this concept, adjustments are made for all prepaid expenses, outstanding expenses, accrued income, etc, while preparing periodic reports.

8. Accrual Concept It is generally accepted in accounting that the basis of reporting income is accrual. The accrual concept makes a distinction between the receipt of cash and the right to receive it and the payment of cash, and the legal obligation to pay it. This concept provides a guideline to the accountant as to how he should treat the cash receipts and the right related thereto. The accrual principle tries to evaluate every transaction in terms of its impact on the owner’s equity. The essence of the accrual concept is that net income arises from events that change the owner’s equity in a specified period and that these are not necessarily the same as the change in the cash position of the business. This it helps in the proper measurement of income.

9. Realisation Concept Realisation is technically understood as the process of converting non-cash resources and rights into money. As an accounting principle, it is used to identify precisely the amount of revenue to be recognised and the amount of expense to be matched to such revenue for the purpose of income measurement. According to realisation concept revenue is recognised when a sale is made. 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. This implies that revenue is generally realised when goods are delivered or services are rendered. The rationale is that delivery validates a claim against the customer. However, in the case of long-run construction contracts revenue is often recognised based on a proportionate or partial completion method. Similarly, in the case of long-run instalment sales contracts, revenue is regarded as realised only in proportion to the actual cash collection. In fact, both these cases are exceptions to the notion that an exchange is needed to justify the realisation of revenue.