Thoery Base of Accounting

Basic Accounting Concepts-

BASIC ASSUMPTION OF ACCOUNTING

• BUSINESS ENTITY ASSUMPTION

From the accounting point of view every business enterprise is an entity separate and distinct from its proprietor(s)/owner(s). The accounting system gives information only about the business and not its owner(s).

• ACCOUNTING PERIOD ASSUMPTION

Those who are interested in the operating results of business obviously cannot wait till the end. The requirements of these parties therefore force the accountant to report for the changes in the wealth of a firm for short time periods. These time periods in actual, practice vary, though a year is the most common interval as a result of established business practice, tradition and government requirements. Some firms adopt calendar year, some others financial year of the government.

Financial year starts from 1^st April and ends on 31^st March.

• ASSUMPTIONS OF MONEY MEASUREMENT

In accounting, only those facts which can be expressed in terms of money are recorded. 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 widely different assets and equities can be expressed in terms of a common denominator. Without this adding heterogeneous factors like five buildings, ten machines, six trucks will not have much meaning.

• GOING CONCERN ASSUMPTION

Accounting assumes that the business (an accounting 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, that is, as continuing in operation, at least in the foreseeable future. The owners have no intention nor have they the necessity to wind up or liquidate its operations.

This assumption provides a basis for the application of cost in accounting for assets.

• DUAL ASPECT PRINCIPLE

This is a basic concept of accounting. According to this concept every business transaction has a two-fold effect. In commercial context it is a famous dictum that "every receiver is also a giver and every giver is also a receiver".

Every business transaction involves two aspects:

1. the receiving aspect, and (ii) the giving aspect

If complete record of transactions is to be made, it would be necessary to record both the aspects in books of account. This principle is the cose of double enuy book-keeping and if this is strictly followed, it is called 'Double Entry System of Book-keeping'.

This equality is called 'balance sheet equation' or 'accounting equation'. It is stated as under : Liabilities (Equities) = Assets

or

Capital + Outside Liabilities = Assets

The term 'assets' denotes the resources (property) owned by the business while the term 'equities' denotes the claims of various parties against the business assets.

 Equities are of two types: (i) owners' equity, and (ii) outsiders' equity.

Owners' equity called capital is the claim of the owners against the assets of the business. Outsiders' equity called liabilities is the claim of outside parties like creditors, bank, etc. against the assets of the business.

Thus, all assets of the business are claimed either by the owners or by the outsiders. Hence, the total assets of a business will always be equal to its liabilities.

• REVENUE RECOGNITION PRINCIPLE

The Revenue recognition principle states that revenue shall be recognized once the underlying goods or services associated with the revenue have been delivered or rendered, respectively. Thus, revenue can only be recognized after it has been earned or its due.

• HISTORICAL COST PRINCIPLE

According to the historical record concept, we record only those transactions which have actually taken place and not those which may take place (future transactions). It is because accounting record presupposes that the transactions are to be identified and objectively evidenced. This is possible only in the case of past (actually happened) transactions.

• MATCHING PRINCIPLE

This is also called 'Matching of Costs against Revenues Concept'. To work out profit or loss of an accounting year, it is necessary to bring together all revenues and costs pertaining to that accounting year. In other words, expenses incurred in an accounting year should be matched with the revenues earned during that year. The crux of the problem, therefore, is that appropriate costs must be matched against appropriate revenues.

• OBJECTIVITY PRINCIPLE

The term objectivity refers to being free from bias or free from subjectivity. Accounting measurements are to be unbiased and verifiable independently. For this purpose, all accounting transactions should be evidenced and supported by documents such as invoices, receipts, cash memos, etc. These supporting documents (vouchers) form the basis for making entries in [he books of account and for their verification by auditors afterward.

• CONVENTION OF FULL DISCLOSURE

Financial statements are the basic means of communicating financial information to all interested parties. These statements are the only source for assessing the performance of the enterprise for investors, lenders, suppliers, and others. Therefore, financial statements and their accompanying foot-notes should completely disclose all relevant information of a material nature which relate to the profit and loss and the financial position of the business. This enables the users of the financial statements to make correct assessment about the profitability and financial soundness of the enterprise. It is therefore necessary that the disclosure should be full, fair and adequate.

• CONVENTION  OF MATERIALITY

This concept is closely related to the Full Disclosure Concept. Full disclosure does not mean that everything should be disclosed. It only means that all relevant and material information must be disclosed. Materiality primarily relates to the relevance and reliability of information. An item is considered material if there is a reasonable expectation that the knowledge of it would influence the decision of the users of the financial statements. All such material information should be disclosed through the financial statements and the accompanying notes.

• CONVENTION OF CONSERVATISM

This is also known as Prudence Concept. This concept tries to ensure that all uncertainties and risks inherent in business are adequately provided for. Accountants generally prefer understatement of assets or revenues, and overstatement of liabilities or costs. This is in accordance with the traditional view which states anticipate no profits but anticipate all losses'. In other words, you should account for profits only when they are actually realised. But in case of losses you should take into account even those losses which may be a remote possibility

• CONVENTION OF CONSISTENCY

The principle of consistency means 'conformity from period to period with unchanging policies and procedures'. It means that accounting method adopted should not be changed from year to year.

If this principle of consistency is not followed, the accounting information about an enterprise cannot be usefully compared with similar information about other enterprises and so also within the same enterprise for some other period. Consistent use of the same methods and bases from one period to another, enhances the utility of the financial statement.

TYPES OF CONSISTENCY:

1.  VERTICAL CONSISTENCY ( Same Organisation)

It occurs when fixed assets have been shown at cost price and in the interrelated income statement depreciation has also been charged on the historical cost of the assets.

1.  HORIZONTAL  CONSISTENCY  (Time basis)

This consistency is to be found between financial statements of one entity from period to period.

1.  DIMENSIONAL CONSISTENCY  (Two organisations in the same  trade)

This consistency is to be found between financial statements of one entity from period to period.

Therefore, as per this convention the same accounting methods should be adopted every year in preparing financial statements.

Generally Accepted Accounting Principles-

Generally accepted accounting principles are usually developed by professional accounting bodies like American Institute of Certified Public Accountants (AICPA) and Institute of Chartered Accountants of India(ICAI). In developing such principles, however, the accounting profession has to reflect the realities of social, economic, legal and political environment in which it operates.

Systems of Accounting

There are two systems of accounting includes-

a). Single entry system

b). Double entry system

A method of writing every transaction in two accounts is known as double entry # system of accounting. Out of these two accounts, one account is given debit and , another accoubt is given credit of an equal amount. Thus, under double entry system for every debit there will be a corresponding credit and vice-versa.

This is considered as the most scientific system that records both aspects of each transaction.

For better understanding of double entry system one has to bear in mind the following factors which are common to every business.

 i) Every business unit deals with a number of persons or firms. Therefore, the personal firms must be recorded in separate category of accounts called personal accounts.

ii) The business concern needs to deal with and/or maintain some assets like cash, stock, furniture, etc. An accountant must keep the detailed record of such accounts which are classified as real or property accounts.

 iii) It is common for every business to have certain resources of income and similarly certain expenses must be incurred to run the business. Therefore, a detailed account of each expense and income is to be recorded in the books of account. Such accounts are known as nominal or fictitious accounts.

BASES OF ACCOUNTING

There are two bases of accounting: (i) cash basis, and (ii) accrual basis. These are explained below:

(i) Cash Basis of Accounting

In this system, the accounting entries are made on the basis of cash received or cash paid. In other words, transactions are recorded only when cash is received or paid. The incomes earned but not yet received (accrued income) or the expenses incurred but not yet paid (expenses outstanding) are completely ignored while preparing the final accounts.

(ii) Accrual Basis of Accounting

Accrual accounting is also called ‘Mercantile System of Accounting’. It recognises that buying, selling and all other operations of an enterprise during a period may not coincide with the period during which the related cash receipts and cash payments take place.