Important accounting concepts

Business Entity Concept:

It is generally accepted that the moment a business enterprise

I started it attains a separate entity as distinct from the persons who own it.

In recording the transactions of a business, the important question is:

How do these transactions affect the business enterprise? The question as to how these transactions affect the proprietors is quite irrelevant. This concept is extremely useful in keeping business affairs strictly free from the effect of private affairs of the proprietors. In the absence of this concept the private affairs and business affairs are mingled together in such a way that the true profit or loss of the business enterprise cannot be ascertained nor its financial position. To quote an example, if a proprietor has taken rs.5000/- from the business for paying house tax for his residence, the amount should be deducted from the capital contributed by him. Instead if it is added to the other business expenses then the profit will be reduced by rs.5000/- and also his capital more by the same amount. This affects the results of the business and also its financial position. Not only this, since the profit is lowered, the consequential tax payment also will be less which is against the provisions of the income-tax act.

Going Concern Concept:

This concept assumes that the business enterprise will continue to operate for a fairly long period in the future. The significance of this concept is that the accountant while valuing the assets of the enterprise does not take into account their current resale values as there is no immediate expectation of selling it. Moreover, depreciation on fixed assets is charged on the basis of their expected life rather than on their market values. When there is conclusive evidence that the business enterprise has a limited life, the accounting procedures should be appropriate to the expected terminal date of the enterprise. In such cases, the financial statements could clearly disclose the limited life of the enterprise and should be prepared from the ‘quitting concern’ point of view rather than from a ‘going concern’ point of view.

Money Measurement Concept:

Accounting records only those transactions which can be expressed in monetary terms. This feature is well emphasized in the two definitions on accounting as given by the american institute of certified public accountants and the american accounting principles board. The importance of this concept is that money provides a common denomination by means of which heterogeneous facts about a business enterprise can be expressed and measured in a much better way. For e.g. When it is stated that a business owns rs.1,00,000 cash, 500 tons of raw material, 10 machinery items, 3000 square meters of land and building etc., these amounts cannot be added together to produce a meaningful total of what the business owns. However, by expressing these items in monetary terms such as rs.1,00,000 cash, rs.5,00,000 worth raw materials, rs,10,00,000 worth machinery items and rs.30,00,000 worth land and building – such an addition is possible.

A serious limitation of this concept is that accounting does not take into account pertinent non-monetary items which may significantly affect the enterprise. For instance, accounting does not give information about the poor health of the chairman, serious misunderstanding between the production and sales manager etc., which have serious bearing on the prospects of the enterprise. Another limitation of this concept is that money is expressed in terms of its value at the time a transaction is recorded in the accounts. Subsequent changes in the purchasing power of money are not taken into account.

Cost Concept:

This concept is yet another fundamental concept of accounting which is closely related to the going-concern concept. As per this concept: (1) an asset is ordinarily entered in the accounting records at the price paid to acquire it i.e., at its cost and (ii) this cost is the basis for all subsequent accounting for the asset.

The implication of this concept is that the purchase of an asset is recorded in the books at the price actually paid for it irrespective of its market value. For e.g. If a business buys a building for rs.3,00,000, the asset would be recorded in the books as rs.3,00,000 even if its market value at that time happens to be rs.4,00,000. However, this concept does not mean that the asset will always be shown at cost. This cost becomes the basis for all future accounting of the asset. It means that the asset may systematically be reduced in its value by changing depreciation. The significant advantage of this concept is that it brings in objectivity in the preparations and presentation of financial statements. But like the money measurement concept, this concept also does not take into account subsequent change in the purchasing power of money due to inflationary pressures. This is the reason for the growing importance of inflation accounting.

Dual Aspect Concept (Double Entry System):

This concept is the core of accounting. According to this concept every business transaction has a dual aspect. This concept is explained in detail below:

The properties owned by a business enterprise are referred to as assets and the rights or claims to the various parties against the assets are referred to as equities. The relationship between the two may be expressed in the form of an equation as follows:

Equities = Assets

Equities may be subdivided into two principal types: the rights of creditors and the rights of owners. The rights of creditors represent debts of the business and are called liabilities. The rights of the owners are called capital.

Expansion of the equation to give recognition to the two types of equities results in the following which is known as the accounting equation:

Liabilities + Capital = Assets

It is customary to place ‘liabilities’ before ‘capital’ because creditors have priority in the repayment of their claims as compared to that of owners. Sometimes greater emphasis is given to the residual claim of the owners by transferring liabilities to the other side of the equation as:

Capital = Assets – Liabilities

All business transactions, however simple or complex they are, result in a change in the three basic elements of the equation. This is well explained with the help of the following series of examples:

(i)        Mr. Prasad commenced business with a capital of rs.3,000: the result of this transaction is that the business, being a separate entity, getscash-asset of rs.30,000 and has to pay to mr. Prasad rs.30,000, his capital.

This transaction can be expressed in the form of the equation as follows:

Capital = Assets

Prasad     Cash

30,000    30,000

(ii)      purchased furniture for rs.5,000: the effect of this transaction is that cash is reduced by rs.5,000 and a new asset viz. Furniture worth rs.5,000 comes in, thereby, rendering no change in the total assets of the business. The equation after this transaction will be:

Capital=Assets

Prasad  Cash + Furniture

30,000  25,000 + 5,000

(iii)    borrowed rs.20,000 from mr. Gopal: as a result of this transaction both the sides of the equation increase by rs.20,000; cash balance is increased and a liability to mr. Gopal is created. The equation will appear as follows:

Liabilities + Capital  = Assets

Creditors + Prasad   Cash + Furniture

20,000        30,000  45,000  5,000

(iv)    purchased goods for cash rs.30,000: this transaction does not affect the liabilities side total nor the asset side total. Only the composition of the total assets changes i.e. Cash is reduced by rs.30,000 and a new asset viz. Stock worth rs.30,000 comes in. The equation after this transaction will be as follows:

Liabilities + Capital =Asset

Creditors     Prasad  Cash  +  Stock  +  Furniture

20,000           30,000  15,000  30,000      5,000

(v)      goods worth rs.10,000 are sold on credit to ganesh for rs.12,000. The result is that stock is reduced by rs.10,000 a new asset namely debtor (mr. ganesh) for rs.12,000 comes into picture and the capital of mr. Prasad increases by rs.2,000 as the profit on the sale of goods belongs to the owner. Now the accounting equation will look as under:

Liabilities + Capital = Asset

Creditors  Prasad  Cash + Debtors + Stock + Furniture

20,000      32,000  15,000  12,000    20,000     5,000

(vi)    paid electricity charges rs.300: this transaction reduces both the cash balance and mr. Prasad’s capital by rs.300. This is so because the expenditure reduces the business profit which in turn reduces the equity. The equation after this will be:

Liabilities + Capital =Assets

Creditors + Prasad   Cash + Debtors + Stock + Furniture

20,000          31,700  14,700  12,000      20,000    5,000

Thus it may be seen that whatever is the nature of transaction, the accounting equation always tallies and should tally. The system of recording transactions based on this concept is called double entry system.

Accounting Period Concept:

In accordance with the going concern concept it is usually assumed that the life of a business is indefinitely long. But owners and other interested parties cannot wait until the business has been wound up for obtaining information about its results and financial position. For e.g. If for ten years no accounts have been prepared and if the business has been consistently incurring losses, there may not be any capital at all at the end of the tenth year which will be known only at that time. This would result in the compulsory winding up of the business. But, if at frequent intervals information are made available as to how things are going, then corrective measures may be suggested and remedial action may be taken. That is why, pacioli wrote as early as in 1494: ‘frequent accounting makes for only friendship’. This need leads to the accounting period concept.

According to this concept accounting measures activities for a specified interval of time called the accounting period. For the purpose of reporting to various interested parties one year is the usual accounting period. Though pacioli wrote that books should be closed each year especially in a partnership, it applies to all types of business organizations.

Periodic Matching Of Costs And Revenues:

This concept is based on the accounting period concept. It is widely accepted that desire of making profit is the most important motivation to keep the proprietors engaged in business activities. Hence a major share of attention of the accountant is being devoted towards evolving appropriate techniques of measuring profits. One such technique is periodic matching of costs and revenues.

In order to ascertain the profits made by the business during a period, the accountant should match the revenues of the period with the costs of that period. By ‘matching’ we mean appropriate association of related revenues and expenses pertaining to a particular accounting period. To put it in other words, profits made by a business in a particular accounting period can be ascertained only when the revenues earned during that period are compared with the expenses incurred for earning that revenue. The question as to when the payment was actually received or made is irrelevant. For e.g. In a business enterprise which adopts calendar year as accounting year, if rent for december 1989 was paid in january 1990, the rent so paid should be taken as the expenditure of the year 1989, revenues of that year should be matched with the costs incurred for earning that revenue including the rent for december 1989, though paid in january 1990. It is on account of this concept that adjustments are made for outstanding expenses, accrued incomes, prepaid expenses etc. While preparing financial statements at the end of the accounting period.

The system of accounting which follows this concept is called as mercantile system. In contrast to this there is another system of accounting called as cash system of accounting where entries are made only when cash is received or paid, no entry being made when a payment or receipt is merely due.

Realization Concept:

Realization refers to inflows of cash or claims to cash like bills receivables, debtors etc. Arising from the sale of assets or rendering of services. According to realization concept, revenues are usually recognized in the period in which goods were sold to customers or in which services were 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. To illustrate this point, let us consider the case of a, a manufacturer who produces goods on receipt of orders. When an order is received from b, a starts the process of production and delivers the goods to b when the production is complete. B makes payment on receipt of goods. In this example, the sale will be presumed to have been made not at the time when goods are delivered to b. A second aspect of the realization concept is that the amount recognized as revenue is the amount that is reasonably certain to be realized. However, lot of reasoning has to be applied to ascertain

as to how certain ‘reasonably certain’ is … yet, one thing is clear, that is, the amount of revenue to be recorded may be less than the sales value of the goods sold and services rendered. For e.g. When goods are sold at a discount, revenue is recorded not at the list price but at the amount at which sale is made. Similarly, it is on account of this aspect of the concept that when sales are made on credit, though entry is made for the full amount of sales, the estimated amount of bad debts is treated as an expense and the effect on net income is the same as if the revenue were reported as the amount of sales minus the estimated amount of bad debts.