Accounting Concepts

Accounting Concepts

As you have already studied, accounting is regarded as the language of business as it is the medium of recording business transactions. The affairs of a business unit are communicated to all interested parties (internal and external) through accounting information which has to be appropriately recorded, classified, summarised and presented.

To make the language convey the same meaning to all people, accountants have agreed on a number of basic concepts that they attempt to follow in accounting activities. These concepts are fundamental ideas or basic assumptions.

Let us now discuss these accounting concepts in detail:

• Business Entity Concept
• Money Measurement Concept
• Cost Concept
• Going Concern Concept
• Dual Aspect Concept
• Realisation Concept
• Accrual Concept

Business Entity Concept

As per the business entity concept, a business has a distinct and separate entity from its owners. This implies that the business and its owners should be treated as separate entities for accounting purposes.

Therefore, recording of every transaction is done whether it is related to the owner or not. As per this concept, it is assumed that one separate entity (owner) is giving money to the other entity (business unit). Therefore, when the owner withdraws money from the business for his personal use (drawings), it is treated as a reduction of the owner’s capital.

Nowadays, the concept of business entity has been extended to accounting separately for various divisions of a business unit so as to record the financial transactions of each division separately. In this way, the concept is useful in determining the results of each responsibility centre separately.

Money Measurement Concept

According to the money measurement concept, only those events are recorded in the books of accounts that can be expressed in terms of money.

For example, sale of goods, payment of expenses or receipt of income. Events that cannot be expressed in terms of money are not recorded in the books of accounts; for example, goodwill, loyalty and honesty of employees. However, these events play an important role in the decision making of an organisation.

Cost Concept

According to the cost concept, all assets of an organisation are recorded in the books of accounts at the purchase price, which includes cost of acquisition, transportation, installation and making the asset ready for use.

For example, if a piece of land is purchased for ₹1,00,000 and its market price is ₹1,50,000, then while preparing financial statements, its purchase value would be considered. Thus, the cost concept is historical in nature and it does not change over the years.

Historical costs help in recording purchase costs objectively. In contrast, if costs are recorded on the basis of market value, the value of assets may change from one period to another, which will create difficulty in comparing financial statements.

Going Concern Concept

As per the going concern concept, a business entity is considered to carry out and continue its operations for an indefinite period of time, i.e., for a long period of time and is not expected to be liquidated in the near future. This assumption is important as it forms the basis for showing the value of assets in the balance sheet.

According to this concept, the organisation would be able to achieve its predetermined goals and contractual obligations from available resources.

For example, an organisation purchases machinery worth ₹45,000 with a life span of 10 years. As per the concept of going concern, some amount of the cost incurred on machinery would be shown as an expense every year and the balance amount would be represented as an asset.

Dual Aspect Concept

The dual aspect concept, also known as duality principle, refers to a fundamental convention of accounting that necessitates the recognition of all aspects of an accounting transaction. According to the dual aspect or the duality concept, each transaction has two aspects or two effects. This implies that both aspects of the transaction must be recorded in the books of accounts. Let us understand the duality concept with the help of examples.

Example: Nitin started his business with an initial capital of ₹10,00,000. After 3 days, he deposited 6,00,000 in the current account of the company. As a result of this transaction, the cash balance will come down to 4,00,000 and at the same time, a new item of ₹6,00,000 will be shown as cash at the bank at the asset side.

The duality principle is expressed in terms of a fundamental accounting equation, which is given as follows:

Assets = Liabilities + Capital/Equity

This basic accounting equation is the core of the double-entry bookkeeping system of accounting. The overall impact of the duality concept is that each transaction has an equal impact on assets and liabilities and the total assets are always equal to total liabilities.

Realisation Concept

According to the realisation or the revenue recognition concept, the revenue that is generated from a business transaction should be included in accounting records only when it is realised. Here, the term ‘realisation’ or ‘revenue recognition’ means the creation of a legal right to receive money. The revenues are realised when cash is received or when the right to receive cash has been created. When revenue is realised, it increases the owner’s capital.

For example, a supplier received an order for supplying goods worth ₹ 20,00,000. He supplied the entire consignment of goods worth ₹ 20,00,000. However, in the given financial year, he received the payment of only ₹12,00,000. The rest amount, 8,00,000 was received in the next year. Therefore, for the given accounting year, only the payment of ₹ 12,00,000 will be considered as realised or the revenue of ₹12,00,000 to have been recognised.

Accrual Concept

As per the accrual concept, revenues are recognised in the period in which they occur irrespective of the fact that cash has been received or not. Similarly, expenses are considered to be recognised when they become payable and not whether the cash has been paid or not. The accrued revenues and expenses must be recorded in the accounting period to which they relate.

For example, an organisation sold certain goods for ₹1,00,000 a few days before the end of an accounting period, but the organisation does not receive the payment in the given accounting period. In this case, the amount is due, but it will be included in the revenue for the given accounting period.

Different accountants have different perspectives, which can result in differences in the preparation of financial statements. The absence of a uniform set of principles while preparing financial statements can make the comparisons difficult and the acceptability of these statements will be unsuitable for the users.

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Basic Accounting Terminology

In accounting, a number of technical terms are commonly used. Without understanding the meaning of these terms, the knowledge of accounting subject remains incomplete. Therefore, it is important to know the meaning of these terms.

Following are the commonly used terms in accounting:

• Entity
• Transaction
• Assets
• Liabilities
• Equity
• Balance Sheet
• Capital
• Working Capital
• Sales
• Revenue
• Expenses and Expenditure
• Profit
• Loss
• Discount
• Voucher
• Goods
• Drawings
• Purchases

Entity

It refers to a type of business that has a definite individual existence. In other words, it is a specifically identifiable business enterprise having a unique set of requirements, laws and tax implications. An accounting system is always devised for a specific business entity.

Transaction

It refers to an event that has some monetary value and takes place between two or more entities. It can be a cash transaction or a credit transaction. Examples of transactions include the purchase of goods, receipt of payment, payment made to a creditor, incurring expenses, etc.

Assets

These are the resources of a business entity that can be expressed in monetary terms. Assets comprise items of economic value that are important for running a business. These items are represented on the assets side of the balance sheet of a business entity in order of their liquidity.

There are two types of assets, namely:

• Non-current assets: These are long-term resources of an organisation, such as land, building, plant and machinery. Non-current assets are also called fixed assets.
  
  
• Current assets: These are short-term resources and can be converted into cash within a year. Examples of current assets are cash, cash equivalent, inventory, account receivables and other prepaid expenses, etc.

Liabilities

These are financial obligations or debts a business entity has to pay some time in future, which results in the outflow of resources. Every business entity (small or large) needs to borrow money or purchase goods on credit at one point in time. Liabilities are shown on the left side of the balance sheet.

There are two types of liabilities, namely:

• Non-current liabilities: These liabilities are generally payable after a period of 1 year. Examples of non-current liabilities are loans from financial institutions, debentures issued by companies, etc.
  
  
• Current liabilities: These are payable within one year; for example, payment of debts, bank overdrafts, etc.

Equity

It refers to the difference between an entity’s total assets and liabilities.

Balance Sheet

It refers to a statement that represents the assets, liabilities ad equity of a business entity.

Capital

It is the amount invested by the owner in the business in the form of cash or any other kind of asset.

Working Capital

It refers to the difference between all current assets and current liabilities of a business entity.

Sales

These are total revenues from goods or services sold to customers. Sales may be cash sales or credit sales.

Revenue

It comprises all incoming money generated by selling products and services or through a business entity’s additional assets, before expenses are taken into account.

Expenses and Expenditure

Expenses refer to costs borne by a business entity in the process of generating revenues. Examples of expenses are depreciation, rent, salaries, wages, interest, electricity bills, etc.

On the other hand, expenditure refers to the amount spent by a business entity for purchasing non-current assets or increasing the value of non-current assets. For example, purchase of machinery, furniture, etc.

Profit

It refers to the excess of revenues over related expenses during an accounting period.

Loss

It refers to the excess of expenses over related revenues during an accounting period. ‰‰

Discount

It refers to the deduction in the prices of goods sold. Discount is given in the two forms. When a concession is offered on list prices of goods, it is called trade discount. This type of discount is given by manufacturers to wholesalers or by wholesalers to retailers.

On the other hand, when a concession is given to the customer for making payment in cash, it is called cash discount.

Voucher

It is written evidence through which financial transactions are recorded in the books of accounts. Examples of vouchers include cash memo (when goods are bought on cash), invoice (when goods are bought on credit) and receipts (when a payment is made).

Goods

These refer to products in which a business entity deals. Remember items that are purchased for use in the business are not referred to as goods. For example, purchase of chairs and cupboards by a furniture dealer are denoted as goods, while for a stationery merchant, these are expenses and not goods.

Drawings

The amount of money or goods withdrawn by the owner of the business entity for personal use is called drawings. Note that drawings reduce the capital of the business.

Purchases

These are goods bought on cash or credit by a business entity for resale. For example, purchase of raw materials or finished goods. Note that the purchase of assets is not considered as purchases as they are not bought for resale purposes.