Accounting is the language through which the performance and financial status of an enterprise is communicated to the outside world. In order that the messages communicated through the accounting language is understood by the users, there should be certain common principles. Accountants all over the world agree on certain basic points on which financial accounting theory and practice are based, which are commonly referred to as ‘accounting concepts’ and ‘accounting conventions’
Accounting Concepts and Conventions are general guidelines that all accountants should know and follow when recording day-to-day business transactions and preparing financial accounts. This unit outlines these main principles.
The term concepts includes those basic assumptions or conditions upon which accounting is based. The reason why some of these ideas should be called concepts is that they are basic assumptions and have a direct bearing on the quality of financial accounting information. The alteration of any of the basic concepts (or postulates) would change the entire nature of financial accounting.
Accounting concepts are also basic assumptions or truths which are accepted by people without further proof. They are conceptual guidelines for application in the financial accounting process. According to Glenn A. Wisch and Daniel G. Short the concepts are important because they
- Help to explain the ‘why’ of the accounting
- Provide guidance to deal with new accounting problems
- There is no need to memorize accounting procedures.
1. Business Entity Concept
In accounting, we differentiate the business and the owner, both are treated as separate entities. Accounts are prepared to give information about the business and not about those who own it. All the records are kept from the viewpoint of the business rather than from that of the owner. A distinction is made between business transactions and personal transactions.
Without such a distinction, the affairs of the business will be mixed up with the private affairs of the proprietor and the true picture of the firm will not be available. The private transactions of the owner will be recorded separately and will have no bearing on the business transactions. All the transactions of the business are recorded in the books of the business from the point of view of the business as an entity and even the proprietor is treated as a creditor to the extent of his capital.
2. Going Concern Concept
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.
According to going concern concept it is assumed that the business will exist for a long time to come. Transactions are recorded in the books keeping in view the going concern aspect of the business unit. A firm is said to be going concern when there is neither the intention nor necessary to wind up its affairs. In other words, it should continue to operate at its present scale in the future. On account of this concept the fixed assets are shown in the balance sheet at a diminishing balance method i.e., going concern value.
There is no need to show assets at market value because these have been purchased for use in future and earn revenues and for sale purpose. If the business is not to continue then market value will have significance. Since business is to continue, fixed assets will be shown at cost less depreciation basis. It is due to the concept that the fixed assets are depreciated on the basis of their expected life than on the basis of market value. The concept also necessitates distinction between expenditure that will render benefit over a long period and that whose benefit will be exhausted quickly, say within one year. The going concern concept also implies that existing liabilities will be paid at maturity.
However, if the accountant has good reasons to believe that the business, or some part of it, is going to be liquidated or that it will cease to operate (say within a year or two), then the resources could be reported at their current values (or liquidation values).
3. Money Measurement Concept:
In accounting, only those transactions 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.
Transactions or events which cannot be expressed in money do not find place in the books of accounts though they may be very useful for the business. For example, if a business has got a team of dedicated and trusted employees, it is definitely an asset to the business, but since their monetary measurement is not possible, they are not shown in the books of business. It should be remembered that money enables various things of diverse nature to be added up together and dealt with. The use of a building and the use of clerical service can be aggregated only through money values and not otherwise.
4. Cost Concept
The resources (land, buildings, machinery, property rights, etc.) that a business owns are called assets. The money values that are assigned to assets are derived from the cost concept. This concept is closely related to the going concern concept.
According to this concept, the asset is recorded in the books at the price at which it was acquired i.e., at its cost price. This cost serves the basis for the accounting of this asset during the subsequent period. The ‘cost’ should not be confused with ‘value’. It must be remembered that as the real worth of the assets changes from time to time, it does not mean that the value of such an asset is wrongly recorded in the books. The book values of the assets as recorded do not reflect their real value. They do not signify that values noted therein are the values for which they can be sold.
Though the assets are recorded in the books at cost, in course of time, they are reduced in value on account of depreciation charges. The idea that the transactions should be recorded at cost rather than at a subjective or arbitrary value is known as cost concept. With the passage of time, the market value of fixed assets like land and buildings vary greatly from their cost. These changes in the value are generally ignored by the accountants and they continue to value them in the balance sheet at historical cost. The principle of valuing the fixed assets at cost and not at market value is the underlying principle in cost concept. According to them the current values alone will fairly represent the cost to the entity.
The cost principle is based on the principle of objectivity. There is no room for personal assessment in showing the figures in accounting records. If subjectivity is flowed in records the same assets will be valued at different figures by different individual. Everybody will have his own views about various assets. The cost concept is helpful in making truthful records. The records become more reliable and comparable.
5. Dual Aspect Concept:
This is the basic concept of accounting. Modern accounting system is based on dual aspect concept. Dual concept may be stated as “for every debit, there is a credit”. Every transaction should have two sided effect to the extent of same amount. For example, if A starts a business with a capital of $10,000. There are two aspects of the transaction. On the one hand the business has assets of $10,000 while on the other hand 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:
Capital (Equities) = Costs (Assets)
10,000 = 10,000
The term ‘assets’ denotes the resources owned by a business while the term ‘equities’ denotes the claims of various parties against the assets. Equities are of two types. They are owners equity and outsiders equity. Owner’s equity (or capital) is the claim of the owner’s against the assets of the business while outsiders equity (liabilities) is the claim of outside parties against the assets of the business. Since all assets of the business are claimed by someone (either owners or outsiders), the total of assets will be equal to total of liabilities. Thus:
Equities = Assets
OR Liabilities + Capital = Assets
Suppose if the business borrows $5000 from a bank, dual aspect of this transaction will be
Capital + Liabilities = Assets
10,000 = 15,000
Thus the accounting Equation states that at any point of time the assets of any entity must be equal (in monetary terms) to the total of owner’s equity and outsider’s liabilities. As a matter of fact the entire system of double entry accounting is based on this concept.
6. Accounting period concept
According to this concept, the life of the business is indefinite. Since the life of the business is considered to be indefinite (according to going concern concept) the measurement of income and studying financial position of the business according to the above concept, after a very long period would not be helpful in taking proper corrective steps at the appropriate time. It is, therefore, absolutely necessary that after each segment or time interval the businessman must stop and see, how things are going on. In accounting such a segment or time interval is called accounting period. It is usually of a year.
This concept facilitates the preparation of income statement and statement of financial position at the end of each accounting year. This helps to ascertain the operating results (profit/loss) and the financial position of the entity. Only the income and expenses pertaining to the accounting period alone is considered for preparing the income statement distinguishing between ‘capital’ and ‘revenue’. Since the statement of financial position reflects all the transactions till the date of its preparation, all items not considered in the preparation of income statement should be considered in its preparation. The concept of annual financial reporting has arisen out of the accounting period concept.
7. Matching concept
The aim of business is to earn profit. In order to ascertain the profit the costs (expenses) are matched to revenue. The difference between income from sales and costs of producing the goods will be the profit. When business is taken as a going concern then it becomes necessary to evaluate the performance periodically.
A correct statement of income requires a distinction between past, present and future expenditures. A distinction between capital and revenue expenditure is also necessary. The revenues and costs of same period are matched. In other words, income made by the business during a period can be measured only when the revenue earned during a period is compared with the expenditure incurred for earning that revenue. The question when the payment was received or made is irrelevant.
8. Realization Concept
This concept emphasises that profit should be considered only when realised. The question is at what stage profit should be deemed to have accrued? Whether at the time of receiving the order or at the time of execution of the order or at the time of receiving the cash? For answering this question the accounting is in conformity with the law and Recognises the principle of law i.e., the revenue is earned only when the goods are transferred. It means that profit is deemed to have accrued when property i goods passes to the buyer, viz., when sales are made.