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The term ' accounting concepts'
includes those basic assumptions or conditions on
which the science of accounting is based. These
concepts are used by accountants and bookkeepers all
over the world. Following
are the most important accounting concepts:
-
Separate entity concept.
- Going
concern concept.
-
Money measurement concept.
- Cost concept.
- Dual
aspect concept.
-
Accounting period concept.
-
Matching concept.
- realization concept.
These accounting concepts are explained below:
Accounts are kept
for entities, as distinguished from the persons who
are associated with these entities. In recording
events in accounting, the important question is:
"How do these events affect the entity?" How they
affect the persons who own, operate, or otherwise
are associated with the entity is irrelevant. For
example, when a person invests $200,000 into
business it will be deemed that the owner has given
that money to the business which will be shown as a
'liability' in the books of the business. In case
the owner withdraws $30,000 from the business, it
will change the position and the net amount payable
by the business to the owner will be shown only as
$170,000.
The concept of
separate entity is applicable to all forms of
business organizations. For example, in case of a
sole proprietorship or partnership business, though
the sole proprietor or partners are not considered
as separate entities in the eyes of law, but for
accounting purposes they will be considered as
separate entities.
According to this
concept it is assumed that an entity is a going
concern - that it will continue to operate for an
indefinite time period there is no intention to
liquidate the particular business venture in the
foreseeable future. On account of this concept, the
accountant while valuing the asset does not take
into account the sale value of assets. Moreover, he
charges depreciation on fixed assets on the basis of
their expected life rather than on their market
values.
For example,
suppose that a company has just purchased a
three-year insurance policy for $45,000. If we assume
that the business will continue in operation for
three years or more. We will consider the $45,000
cost of insurance as an asset which provides
services to the business over a three-year period.
On the other hand, if we assume that the business is
likely to terminate in the near future, the
insurance policy should be reported at its
cancellation value i.e. the amount refundable upon
cancellation.
Moreover, the
concept applies to the business as a whole. When an
enterprise liquidates a branch or one segment of its
operations, the ability of the enterprise to
continue as a going-concern is not impaired
normally. The enterprise will not be considered as a
going-concern when it has gone into liquidation.
In financial accounting, a record is made only of those
information that can be expressed in monetary terms.
In other words, no accounting is possible for an
event or transaction which is not measurable in
terms of money, e.g. passing an examination,
delivering lecture in a meeting, winning a prize
etc. These are events no doubt, but since these are
not measurable in terms of money, there is no
question of their accounting.
Measurement of
business events in money helps in understanding the
state of affairs of business in a much better way.
For example, If a business owns. 1,500kg of stock,
one car, 1,500 square feet of building space etc.
these amounts cannot be added to produce a
meaningful total of what the business owns. However,
if these items are expressed in monetary
terms such as stock $24,000, car $300,000 and
building $500,000, all such items can be added in
better way and precise estimate about the assets of
the business will be available.
The concept is
closely related to going concern concept. According
to this concept. "An asset is ordinarily entered on
the accounting record at the price paid to acquire
it, and this cost is the basis for all subsequent
accounting for the asset". If business buys a
building for $5,00,000, the assets would be recorded
in the books at $500,000, even if its market value
at that time may be $550,000. In case a year later
the market value of this asset comes down to
$450,000 it will ordinarily continue to be shown at
$500,000 and not at $450,000.
The cost concept
does not mean that the asset will always be shown at
cost. It has also been stated above that cost
becomes the basis for all future accounting for the
asset. It means that asset is recorded at cost at
the time of purchase but it may systematically be
reduced in its value by charging depreciation.
The economic
resources of an entity are called 'assets'. The
claims of various parties against these assets are
called 'equities'. There are two types of equities:
- Liabilities,
which are the claims of creditors (that is,
everyone other than the owners of business) and
- Owner's
Equity, which is the claim of the owners of the
business.
Since all of the
assets of a business are claimed by someone (either
by its owners or by its creditors) so we can say that
Assets = Equities
This is the
fundamental accounting equation, which is the formal
expression of the dual - aspect concept. As we shall
see all accounting procedures are derived from this
equation. To reflect the two type of equities, the
equation is more commonly expressed as:
Assets = Liabilities + Owner's Equity
Every transaction
has a dual impact on the accounting records.
Accounting systems are set up so as to record both
of these aspects of a transaction; this is why
accounting is called a double-entry system.
To illustrate the
dual-aspect concept, suppose that Mr. A starts a
business with a capital of $30,000. There are two
changes, first the business has cash (asset) of
$30,000 and second, the business has to pay to the
proprietor a sum of $10,000 which is taken as
proprietor's capital. This expression can be shown
in the form of following equation:
Cash
(Assets) = Capital (Equities) $30,000 = $30,000.
Subsequently if the
business borrows $15,000 from a bank, the new
position would be as follows:
Assets = Equities
Cash $30,000
+ Bank $15,000 = Bank loan $15,000 + Capital $30,000.
The term 'accounting equation' is also used to
denote the relationship of equities to assets. The
equation can be technically, stated as "for every
debit, there is an equivalent credit".
The users of
financial statements need information that is
reasonably current. Therefore, for financial
reporting purposes, the life of a business is
divided into a series of relatively short accounting
periods of equal length. It is, therefore,
absolutely necessary that after each accounting
period the business must 'stop' and 'see back', how
things are going. In accounting such accounting
period is usually of a year.
At the end of each
accounting period an income statement and a balance
sheet is prepared the income statement discloses the
profit or loss made by business during the year
while balance sheet shows the financial position of
business as on the last day of the accounting
period.
A significant
relationship exists between revenue and expenses.
Expenses are incurred for the purpose of producing
revenue. In measuring net income for a period,
revenue should be offset by all the expenses
incurred in producing that revenue. This concept of
offsetting expenses against revenue on the basis of
"cause and effect" is called the Matching Concept.
The term 'matching'
means appropriate association of related revenues
and expenses. In matching expenses against revenue
the question when the payment was made or received
is 'irrelevant'. For example if a salesman is paid
commission in January, 2005, for sales made by him
in December, 2004. According to this concept
commission expense should be offset against sales of
December 2004 because this expense is incurred for
producing revenue in December 2004. On account of
this concept, adjustments are made for all
outstanding expenses, accrued revenues, prepaid
expenses and unearned revenues, etc., while
preparing the final accounts at the end of
accounting period.
Accounting to this
concept revenue should be recognized at the time
when goods are sold or services are 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. The following example will
help to understand this point. Mr. A places an order
to Mr. B for supply of certain goods. Mr. B sends
goods to Mr. A 15 days after he has received the
order and Mr. A makes payment 10 days after receipt
of goods. In this case the sale will be presumed to
have been made not at the time of receipt of the
order for the goods or receipt of payment but at the
time when goods are delivered to Mr. A. |
