CONCEPTS OF ACCOUNTANCY

Basic Accounting Concepts

 The basic accounting concepts are referred to as the fundamental ideas or basic assumptions underlying the theory and practice of financial accounting and are broad working rules for all accounting activities and developed by the accounting profession. The important concepts have been listed as below:

Cost concept

The cost concept requires that all assets are recorded in the book of accounts at their purchase price, which includes cost of acquisition, transportation, installation and making the asset ready to use. The cost principle implies that assets like building, plant, machinery etc. are recorded in the book of accounts at a price paid (to be paid in future) for them.

An asset will not always be shown at its original cost because with a passage of time or wear and tear, the value of an asset decreases. Hence the original cost may be systematically reduced by charging depreciation as a fixed percentage of original cost or diminished cost, as the case may be. Hence, cost for used assets means original cost less depreciation to date, (that is book value or carrying value). For new assets, cost means original cost for the new assets. In other words the value at which the asset is shown in the balance sheet has no connection with the market value.

Business Entity Concept

The concept of business entity assumes that business has a distinct and separate entity from its owners. It means that for the purposes of accounting, the business and its owners are to be treated as two separate entities. Keeping this in view, when a person brings in some money as capital into his business, in accounting records, it is treated as liability of the business to the owner. Here, one separate entity (owner) is assumed to be giving money to another distinct entity (business unit). Similarly, when the owner withdraws any money from the business for his personal expenses(drawings), it is treated as reduction of the owner’s capital and consequently a reduction in the liabilities of the business. The accounting records are made in the book of accounts from the point of view of the business unit and not that of the owner. The personal assets and liabilities of the owner are, therefore, not considered while recording and reporting the assets and liabilities of the business. Similarly, personal transactions of the owner are not recorded in the books of the business, unless it involves inflow or outflow of business funds.

Money Measurement Principle

According to this principle, all business transactions must be recorded in the books of accounts in terms of the standard currency of the country where the business is set up. For example, in India it is done in terms of Rupees, in USA it is done in terms of dollars, in Japan in terms of Yen, in Bangladesh in terms of Takka and so on. The reason for choosing money for recording business transaction is that generally a business deals in a variety of terms having different physical units such as kilograms, quintals, tons, meters, liters, gallons etc. If sales and purchases of different terms are recorded in terms of their physical units, adding them together is not possible because of different or unlike units. Moreover, it is not possible to determine the total value of the assets owned by a business enterprise by adding, say one building, two machines, four tables, ten chairs, brand name etc., because they are in unlike physical units. Money is a common unit for recording purchases, sales, assets, liabilities capital, and payments of expenditure like salaries, rent etc. and receipts of interest and so on. In this manner money, as a common unit of measurement enables a business enterprise to find out profit or loss through income statement and determine the financial position with the help of balance sheet. This approach of money measurement has following limitations.

1. It assumes that the purchasing power of money does not change over time. This is not true because the purchasing power of every currency (rupees, dollars, yens etc.) changes under periods of rising prices (i.e., inflation unlike physical units such as kilometers, a liter, a metric ton etc.
2.  Another limitation with money measurement principle is that it does not take into consideration the quality of management or its products or death of an efficient manager etc., because these events cannot be measured in terms of money. Similarly, purchased goodwill or trade mark is recorded in the books of account but goodwill or trademark resulting from the successful running of the business is omitted from accounting records.

Realization Concept

Realisation means as to when a transaction gets a legal right to the receipt of money. In other words, realisation concept is related to the precise time when revenue is to be recognised in the books of account of the firm.

For example an Indica car manufactured in the year 2007 is kept in the showroom throughout 2008. It is sold in 2009 and cash is collected against it sale in 2010. If the cost of the Indica Model is Rs. 2, 40,000 and selling price Rs. 3, 00,000 the profit is obviously Rs. 60,000. Since the income statement is prepared every year, that is 2007,2008,2009 and 2010; the problem is how the profit of Rs. 60,000 is to be divided between these four accounting periods.

 According to Realisation concept, whole of the profit is to be recognized in 2009 when the revenue of Rs. 2, 40,000 becomes the revenue of the business enterprise. In short, the realization of revenue takes place when goods or services have been sold either for cash or on credit. Thus 'sale' is necessary for recognition of revenue in the books of account.

• Dual Concept.

Dual aspect is the foundation or basic principle of accounting. It provides the very basis for recording business transactions into the book of accounts. This concept states that every transaction has a dual or two-fold effect and should therefore be recorded at two places.

In other words, at least two accounts will be involved in recording a transaction. This can be explained with the help of an example. Ram started business by investing in a sum of Rs. 50,00,000. The amount of money brought in by Ram will result in an increase in the assets (cash) of business by Rs. 50,00,000. At the same time, the owner’s equity or capital will also increase by an equal amount. It may be seen that the two items that got affected by this transaction are cash and capital account

According to this principle, every transaction has two-fold effect and is commonly expressed in the form of a fundamental accounting equation:

Assets = Equities (Claims)

 OR

Assets = Capital + Outside Liabilities

An entity's financial position is reflected by the relationship of the assets to liabilities and capital.

Assets are resources of the firm which can be expressed in money terms.

Liabilities are obligations in the form of money to be paid or services to be rendered or performed by the business.

Capital is the contribution or investment of the owner in the assets of the business which contributes to the difference between assets and liabilities. In a sole proprietorship, there is only one capital account while in a partnership business; there is a capital account for each partner. It represents the investment of the shareholders.

The idea behind this fundamental equation is that somebody has a claim on the assets of the business enterprise. The claimants may be either the owner(s) or the lenders. It is this relationship from which the term Balance Sheet is derived.

• Historical records cost

In the accounting process, the transactions are first identified and than measured in terms of money before they are recorded in the books of account. Record only those transactions which have actually taken place. As in history books we find description of past events/so in account books we find recording of past transactions. In simple words, transactions are recorded in books of account as and when they take place in a chronological manner (date wise). This process of recording transactions data wise is called historical can hardly be identified and measured accurately. Future forecasts are based on estimates and their measurement is only approximate. It is a subject matter of management accounting and not that of Financial Accounting.

It is true that an accountant makes provisions for some expected losses such as doubtful debts. Such provisions are made only at the end of the accounting period to ascertain the true profits. It is not a routine item. This is done in accordance with other accounting principle called convention of conservativism or prudence to be explained along with the principles related to reporting.

• Objective Evidence concept-

The concept of objectivity requires that accounting transaction should be recorded in an objective manner, free from the bias of accountants and others. This can be possible when each of the transaction is supported by verifiable documents or vouchers. For example, the transaction for the purchase of materials may be supported by the cash receipt for the money paid, if the same is purchased on cash or copy of invoice and delivery challan, if the same is purchased on credit. Similarly, receipt for the amount paid for purchase of a machine becomes the documentary evidence for the cost of machine and provides an objective basis for verifying this transaction. One of the reasons for the adoption of ‘Historical Cost’ as the basis of recording accounting transaction is that adherence to the principle of objectivity is made possible by it. As stated above, the cost actually paid for an asset can be verified from the documents but it is very difficult to ascertain the market value of an asset until it is actually sold. Not only that, the market value may vary from person to person and from place to place, and so ‘objectivity’ cannot be maintained if such value is adopted for accounting purposes.

• Going Concern Concept

The concept of going concern assumes that a business firm would continue to carry out its operations indefinitely, i.e. for a fairly long period of time and would not be liquidated in the foreseeable future. This is an important assumption of accounting as it provides the very basis for showing the value of assets in the balance sheet. An asset may be defined as a bundle of services. When we purchase an asset, for example, a personal computer, for a sum of Rs.  50,000, what we are buying really is the services of the computer that we shall be getting over its estimated life span, say 5 years. It will not be fair to charge the whole amount of Rs. 50,000, from the revenue of the year in which the asset is purchased. Instead, that part of the asset which has been consumed or used during a period should be charged from the revenue of that period. The assumption regarding continuity of business allows us to charge from the revenues of a period only that part of the asset which has been consumed or used to earn that revenue in that period and carry forward the remaining amount to the next years, over the estimated life of the asset. Thus, we may charge Rs.10,000 every year for 5 years from the profit and loss account. In case the continuity assumption is not there, the whole cost Rs. 50,000 in the present example) will need to be charged from the revenue of the year in which the asset was purchased.

• Matching Concept-

The process of ascertaining the amount of profit earned or the loss incurred during a particular period involves deduction of related expenses from the revenue earned during that period. The matching concept emphasises exactly on this aspect. It states that expenses incurred in an accounting period should be matched with revenues during that period. It follows from this that the revenue and expenses incurred to earn these revenues must belong to the same accounting period. As already stated, revenue is recognised when a sale is complete or service is rendered rather when cash is received. Similarly, an expense is recognised not when cash is paid but when an asset or service has been used to generate revenue. For example, expenses such as salaries, rent, insurance are recognised on the basis of period to which they relate and not when these are paid. Similarly, costs like depreciation of fixed asset is divided over the periods during which the asset is used

The matching concept, implies that all revenues earned during an accounting year, whether received during that year, or not and all costs incurred, whether paid during the year, or not should be taken into account while ascertaining profit or loss for that year.

• Accounting period Concept

Accounting period refers to the span of time at the end of which the financial statements of an enterprise are prepared, to know whether it has earned profits or incurred losses during that period and what exactly is the position of its assets and liabilities at the end of that period. Such information is required by different users at regular interval for various purposes, as no firm can wait for long to know its financial results as various decisions are to be taken at regular intervals on the basis of such information. The Companies Act 2013 and the Income Tax Act require that the income statements should be prepared annually. However, in case of certain situations, preparation of interim financial statements become necessary. For example, at the time of retirement of a partner, the accounting period can be different from twelve months period. Apart from these companies whose shares are listed on the stock exchange, are required to publish quarterly results to ascertain the profitability and financial position at the end of every three months period

 Rules of Debit and Credit

• Traditional approach
• Modern Approach

 All accounts are divided into five categories for the purposes of recording the transactions:

 (a) Asset

 (b) Liability

(c) Capital

 (d) Expenses/Losses, and

 (e) Revenues/Gains. Two fundamental rules are followed to record the changes in these accounts:

(1) For recording changes in Assets/Expenses (Losses):

 (i) “Increase in asset is debited, and decrease in asset is credited.”

 (ii) “Increase in expenses/losses is debited, and decrease in expenses/ losses is credited.”

 (2) For recording changes in Liabilities and Capital/Revenues (Gains):

 (i) “Increase in liabilities is credited and decrease in liabilities is debited.”

 (ii) “Increase in capital is credited and decrease in capital is debited.”

 (iii) “Increase in revenue/gain is credited and decrease in revenue/gain is debited.”

• The term transaction cycle includes Interactions between entity and suppliers-

1. Revenue cycle
2. Payroll cycle
3. Expenditure cycle
4. None of the above

Answer - c)Expenditure cycle

The expenditure cycle is the set of activities related to the acquisition of and payment for goods and services. These activities include the determination of what needs to be purchased, purchasing activities, the receipt of goods, and payments to suppliers.

• Accounting provides information on-

1. Expenses & incomes to the managers
2. Solvency position of companies
3. Tax liability of the company
4. All of the above

Answer- d) All of the above

Accounting provides income on profit , tax liabilities and financial wealth of the entity.

• The written evidence for recording the business transaction is termed as-

1. Journal
2. Trial balance
3. Voucher
4. ledger

Answer-  c) Voucher

Any written form of recording of business transaction is termed as voucher. It becomes the base for proofs.