The compilation of these Theory Base of Accounting Notes makes students exam preparation simpler and organised.
Basic Accounting Concepts
Accounting is both a science and an art. And just like all other streams of science, even in accounting certain rules are followed. Also, accounting is based on certain assumptions as well. We call these accounting concepts or accounting concepts and principles. Let us study accounting concepts and applications in brief.
Accounting Concepts and Conventions
Financial Accounting both practical and theory-based is built on some accounting principles. There are some accounting equations that support these too. And these accounting principles are built on a few assumptions that we call accounting concepts. These thirteen accounting concepts find wide acceptance across the world by accounting professionals and auditors.
1. Business Entity Concept
This accounting concept separates the business from its owner. As far as accounting is concerned the owner and the business are two separate entities. This will help the accountant identify the business transactions from the personal ones. All forms of business organizations (proprietorship, partnership, company, AOP, etc) must follow this assumption.
So for example, if the owner brings in additional capital into the business, we will treat this as a liability on the balance sheet of the business.
2. Money Measurement Concept
This accounting concept states that only financial transactions will find a place in accounting. So only those business activities that can be expressed in monetary terms will be recorded in accounting. Any other transaction, no matter how significant, will not find a place in the financial accounts.
So for example, if the company underwent a major management overhaul this would have no effect on the accounting records. This concept is actually one of the major drawbacks of accounting.
3. Going Concern Concept
The going concern concept assumes that a business will continue to operate indefinitely. So it assumes that for the foreseeable future the business will not be winding up. This leads to the assumption that the business will not have to sell its assets any time soon and it will meet all its obligations as well.
So it justifies the financial statements as a part of a continuous series of statements. The current statements are tentative and only reflect the financial position of that particular period of time.
4. Accounting Period Concept
Every organization, according to its needs, chooses a specific period of time to complete an accounting cycle. Generally, the time chosen is a year we call the accounting year. The time period is mentioned in the financial statements.
So the indefinite life of an organization is divided into the shorter, generally equal time periods. This facilitates a comparison of performances and allows stakeholders to get timely information. Also in most cases, it is also a statutory requirement.
5. Cost Concept
This accounting concept states that all assets of the firm are entered into the books of account at their purchase price (cost of acquisition + transport + installation etc). In the subsequent years to, the price remains the same (minus depreciation charged). The market price of the asset is not taken into consideration.
6. Dual Aspect Concept
This concept is the basic principle of accounting, it is the heart and soul. It basically is one of the golden rules of accounting – for every credit, there must be a corresponding debit. So every transaction we record must have a two-fold effect, i.e. it will be recorded in two places. This is the core concept of the double-entry system of accounting.
So let us see an example of this in action. Say the business buys an asset worth Rs 10,000/-. So now the Fixed Assets of the company will increase by 10,000/-. But at the same time, the bank or cash balance will reduce by 10,000/-. And so the transaction will have a dual effect in accounting. And also the Balance Sheet will stay balanced.
7. Realisation Concept
According to the realization accounting concept, revenue is only recognized when it is realized. Now revenue is the cash inflow for a business arising from the sale of goods or services. And we assume this revenue is realized only when it legally arises to be received. So in simpler terms, the profit earned will be recorded when it is actually earned.
8. Matching Concept
This concept states that the revenue and the expenses of a transaction should be included in the same accounting period. So to determine the income of a period all the revenues and expenses (whether paid or not) must be included.
The matching accounting concept follows the realization concept. First, the revenue is recognized and then we match the costs associated with the revenue. So costs are matched with revenue, the reverse would be an incorrect system.
9. Full Disclosure Concept
This concept states that all relevant information will be disclosed in the accounting statements. A lot of external users depend on these financial statements for their information to make investing decisions. So no information/transactions etc of relevance to anyone of them will be omitted from these statements for the benefit of the company.
10. Consistency Concept
Once the company decides on a certain accounting policy it should not be frequently changed. Unless there is a statutory requirement or it allows a better representation of the accounts accounting policies should be consistent for long periods of time. This allows users to make inter-firm and inter-period comparisons. Also, frequent changes in policies may be to manipulate the accounts and this must be prevented.
11. Conservatism Concept
This accounting concept promotes prudence in accounting. It states that profit should not be included until it is realized. However, losses even those not realized but with the remote possibility of occurring should be included in the financial statements. So all losses are recognized – those that have occurred or are even likely to occur. But only realized profits are recognized.
12. Materiality Concept
Materiality states that all material facts must be a part of the accounting process. But immaterial facts, i.e. insignificant information should be left out. The materiality of a transaction will depend on its nature, value, and its significance to the external user. If the information can affect a person’s investing decision then it is definitely a material fact.
13. Objectivity Concept
Finally, we come to the last accounting concept – objectivity. This concept states the obvious assumption that the accounting transaction recorded should be objective, i.e. free from any bias of the person recording it. So each transaction should be verifiable by supporting documents like vouchers, bills, letters, challans, certificates, invoices, etc.
Example:
Question:
According to__________ accounting concepts, while preparing accounts we anticipate losses.
a. Materiality
b. Objectivity
c. Conservatism
d. None of the above
Answer:
The correct option is “c”.
Conservatism is the policy of anticipating future losses but not recognizing future gains.