L-3-Basic Accounting Concepts

CHAPTER 3

Basic Accounting Concepts

These are the fundamental ideas or basic assumptions on the basis of which accounting is done. Concepts are those basic assumptions and conditions, which form the basis upon which the accountancy has been laid. Unlike physical science, accounting concepts are only result of broad consensus.

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.

Money Measurement Concept

The concept of money measurement states that only those transactions and happenings in an organisation which can be expressed in terms of money such as sale of goods or payment of expenses or receipt of income, etc., are to be recorded in the book of accounts. It means only those transactions will be recorded which can be measured in money. Transactions and events that can’t be expressed in terms of Money aren’t recorded in the business books.

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. The financial statements are prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future.

The Valuation of Assets of a business entity is dependent on this assumption. Traditionally, Accountants follow historical cost in majority of the cases.

Accounting Period Concept/Periodicity 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. The

financial statements are prepared at regular interval, normally after a period of one year, so that timely information is made available to the users. This interval of time is called accounting period. In India, we follow financial year as Accounting Period. E.g., Financial year 2019-20. It will start on 1st April 2019 and end on 31st March 2020.

Accrual Concept

Under Accrual Concept, the effects of transactions and other events are recognised on accrual/mercantile basis i.e., when they occur (and not when cash is received or paid). E.g., Salary of staff for the month of March will be expense of March though the business may pay the salary of staff in April. As per Accrual concept: Revenue- Expenses = Profit.

Accrual concept provides the foundation on which the structure of present-day accounting has been developed.

Cost Concept/ Historical 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. It is also called Historical Cost Concept. When a machine is purchased by paying Rs 5,00,000, following cost concept the value of Machinery will be recorded as Rs 5,00,000 in books of accounts.

Dual Aspect 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 ` 50,00,000. The amount of money brought in by Ram will result in an increase in the assets (cash) of business by ` 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. Let us take another example to understand this point further. Suppose the firm purchase goods worth ` 10,00,000 on cash. This will increase an asset (stock of goods) on the one hand and reduce another asset (cash) on the other. Similarly, if the firm purchases a machine worth ` 30,00,000 on credit from Reliable Industries. This will increase an asset (machinery) on the one hand and a liability (creditor) on the other. This type of dual effect takes place in case of all business transactions and is also known as duality principle. The duality principle is commonly expressed in terms of fundamental Accounting Equation, which is as follows: Assets = Liabilities + Capital

Revenue Recognition (Realisation) Concept

The concept of revenue recognition requires that the revenue for a business transaction should be included in the accounting records only when it is realised. Here arises two questions in mind. First, is termed as revenue and the other, when the revenue is realised. Let us take the first one first. Revenue is the gross inflow of cash arising from (i) the sale of goods and services by an enterprise; and (ii) use by others of the enterprise’s resources yielding interest, royalties and dividends. Secondly, revenue is assumed to be realised when a legal right to receive it arises, i.e. the point of time when goods have been sold or service has been rendered. Thus, credit sales are treated as revenue on the day sales are made and not when money is received from the buyer. As for the income such as rent, commission, interest, etc. these are recognised on a time basis. For example, rent for the month of March 2017, even if received in April 2017, will be taken into the profit and loss account of the financial year ending March 31, 2017 and not into financial year beginning with April 2017.

Matching Concept

It states that expenses incurred in an accounting period should be matched with revenues during that period. The matching concept, thus, 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.

This concept is based on Accrual Concept as it considers the occurrence of expenses and Income and don’t concentrate on actual inflow or outflow of cash. This leads to adjustment of certain items like prepaid and outstanding expenses.

Periodic Profit = Periodic Revenue – Matched Expenses.

Consistency Concept

It states that same accounting policies should be followed in each year so that there is not any bias involved and the financial statements of each year can be compared. For E.g., If an enterprise follows Straight Line Method for depreciation, it should follow the same method in all years.

Conservatism Concept (Prudence)

It states that profits should not be anticipated but losses should be provided for. The concept of conservatism requires that profits should not to be recorded until realised but all losses are to be provided for in the books of account i.e., provision should be made for probable losses.

Materiality Concept

The concept of materiality requires that accounting should focus on material facts. This principle permits other concepts to be ignored, if the effect is not considered material. The term Materiality is a subject term. It is on the judgement, common sense and discretion of the accountant that which item is material and which is not. For example, stationery purchased by the organization though not used fully in the accounting year purchased still shown as an expense of that year because of the materiality concept. Similarly, small items like calculator, books etc which may be used for more than one year are written off to Profit & loss account in first year of purchase being of very insignificant value.

Fundamental Accounting Assumptions

Fundamental Accounting Assumptions are: -

Going Concern concept
Consistency
Accrual

These 3 fundamental assumptions are assumed to be followed by a busines while preparing the books of accounts. If these haven't been followed then the same needs to be mentioned.

Systems of Accounting

The systems of recording transactions in the book of accounts are generally classified into two types, viz. Double entry system and Single-entry system.

Double entry system is based on the principle of “Dual Aspect” which states that every transaction has two effects, viz. receiving of a benefit and giving of a benefit. Each transaction, therefore, involves two or more accounts and is recorded at different places in the ledger. The basic principle followed is that every debit must have a corresponding credit. Thus, one account is debited and the other is credited.

Single entry system is not a complete system of maintaining records of financial transactions. It does not record two-fold effect of each and every transaction. Instead of maintaining all the accounts, only personal accounts and cash book are maintained under this system. The system is, however, followed by small business firms as it is very simple and flexible

Basis of Accounting

From the point of view the timing of recognition of revenue and costs, there can be two broad approaches to accounting. These are:

(i) Cash basis; and

(ii) Accrual basis.

Under the cash basis, entries in the book of accounts are made when cash is received or paid and not when the receipt or payment becomes due. Let us say, for example, if office rent for the month of December 2014, is paid in January 2015, it would be recorded in the book of account only in January 2015.

Under the accrual basis, however, revenues and costs are recognised in the period in which they occur rather when they are paid. A distinction is made between the receipt of cash and the right to receive cash and payment of cash and legal obligation to pay cash. Thus, under this system, the monitory effect of a transaction is taken into account in the period in which they are earned rather than in the period in which cash is actually received or paid by the enterprise.

YouTube Link for Lecture: https://youtu.be/ABJPWRhDntg

Channel Name: Lateef’s Commerce Academy

Links to this page: