2. Basic Accounting Concepts

Basic Accounting Concepts

Accounting Principles

Principles of Accounting are the general law or rule adopted or proposed as a guide to action, a settled ground or basis of conduct or practice. Accounting principles are man-made. Unlike the principles of physics, chemistry, and the other natural sciences, accounting principles were not deducted from basic axioms, nor is their validity verifiable by observation and experiment. Instead, they have evolved. This evolutionary process is going on constantly; accounting principles are not “eternal truths”.

Business Entity Concept

This concept considers a business unit as a separate entity. Business and businessman are two separate entities and all the business transactions are recorded in the books of accounts from business point of view.

Dual Aspect Concept

This Concept also known as equivalence concept signifies that every business transaction has two fold effects or every transaction affects at least two accounts. This concept is, in fact, the base on  which Double Entry System of Book-Keeping is based. According to this principle, every debit has a corresponding credit.

Accounting Period Concept

According to this concept the long life of business is divided into justifiable accounting periods so as to help businessman to know the results of his investment during each such period. This period is known as accounting period and the length of this period depends on the nature of business. Accounting period may be either a calendar year (From January 1 to December 31) or the fiscal year of the Govt. (April 1 to March 31)

Going Concern Concept

This concept assumes that every business has a long and indefinite life. Since financial statements are prepared on the basis of this concept, all fixed assets are shown in the books at their cost ignoring their market value.

Cost Concept

According to this concept all fixed assets are recorded in the books at cost i.e. the price paid to acquire them. Any subsequent increase or decrease in their value will not be shown in the records except the depreciation of these assets. In subsequent years, therefore fixed assets are shown at cost less depreciation provided on them up to date. Continuous charging of depreciation on the asset will ultimately eliminate the asset from the books.

Money Measurement Concept

According to this concept only those transactions are recorded in the books of accounts which can be expressed in monetary terms. The non-financial or non-monetary transactions do not find any place in the accounting records. Money is the common denominator to denote the value of the various assets of diverse nature to give a meaningful total of these assets.

Matching Concept

This concept states that it is necessary to charge all the expenses incurred to earn revenue during the accounting period against that revenue in order to ascertain the net income or trading results of the business. The matching concept which is so closely related to accrual concept and accounting period concept helps a businessman in realizing his objective i.e. in ascertaining the trading results or profit or loss from the business. For ascertaining the net income.

 Accounting Equivalence Concept

According to this concept assets owned by the business must be equal to the funds contributed by the businessman in the form of capital. These days when business is to be carried on a large scale, funds may be borrowed from third parties to supplement the funds contributed by the proprietor.

Realization Concept

According to this concept income is treated as being earned on the date on which it is realized i.e. the date on which goods or services are transferred to the customers. Since this exchange of goods or services may be for cash or on credit, it is not important whether cash has actually been received or not.

Objective Evidence Concept or Verifiable Objective Concept

This concept justifies the significance of verifiable documents supporting various transactions. According to it, each transaction should be supported by objective evidences like vouchers. Objective evidence, here, means evidence free from bias of the accountant.

Materiality

This principle emphasizes that only those transactions should be recorded which are material or relevant for the determination of income from the business. All immaterial facts should be ignored.

Full Disclosure

This concept implies that financial statements should disclose all material information which is required by the proprietor and other users to assess the final accounts of the business unit

Consistency

This principle requires that accounting practices, methods and techniques used by a business unit should be consistent. A business unit can adopt any accounting practice, but once a particular practice is chosen, it must be used for a number or years.

Conservatism or Prudence

This principle is nothing but a formal expression of the maxim “Anticipate no profits and provide for all possible losses.” In other words, it considers all possible losses but ignores all possible profits.

Timeliness of Information

Accounting information to the management should be supplied in time and frequently so that some rational decisions may be taken. If information is not supplied in time, it will obstruct the quick decision-making process of the undertaking.

Accounting assumptions

It is mandatory for every relisted company to get its accounts audited by an independent chartered accountant. 

This has to be done for the use of financial statements. Whenever a company’s accounts are closed on 31st March, the CA goes and checks the correctness of the profit and loss account balance sheet and if you are reported to shareholders that everything is true and fair.

Accounting assumptions are three points which are assumed by the CA that comma these three assumptions are followed by the company while making the final accounts that is profit and loss and balance sheet.

Going concern assumption

Under this assumption, it is assumed that the business is going to continue for the next possible future that is there is no hurdle and the company’s operations are running smoothly.

Now, why is something so obvious an important accounting assumption let's understand the help of a scenario.

Imagine a scenario where there is a fire in the companies goes down biggest godown and all the production has stopped temporarily. 

If the owner lets out this information that the production has stopped immediately the market value will go down the creditors will get upset the banks who have given loans will get alerted it will create more problems for the company because a company always wants to survive.

To protect the uses of financial statements is important for the CA to give his report on whether the fundamental accounting assumption of going concerned has been affected or not

What will happen if the going concern of a company is affected

The difference between capital expenditure and revenue expenditure is over. If there is no distinction between revenue expenditure and capital expenditure. All the major expenditures are considered as expenses and they're expensed out in the profit and loss accounts.

Accrual

In old times how did businessmen calculate their profit and losses? It was very simple to add all the cash which has been received in a given year and subtract all the payments made this year if there is any cash left in its profits.

Companies act 2013 does not follow this manner of accounting. Companies act says that it doesn't matter whether cash has been received or not in a given year. What matters is whether it was this current year's income. 

Let us say that rent per month is rs 1000 yearly rent becomes 1000 into 12000 rupees. You have been the rent for April to December that is 1000 into 9 9000 rupees but you could not pay for January 2 March 3 months 3 into 3000. 

As per accrual, it doesn't matter how much cash you have paid you have to account for the entire 12 months expense.

Similarly, it does not matter if you have received the income in cash or not what matters is it the income of the current year

Income of the current year minus expense of the current year can only give us the profit for the whole year. 

In the case of cash basis of accounting, it is difficult and almost impossible to get the profit for the whole 12 months if you are not considering income and expenses for the 12th months. 

There are four accounts that we will study in the approval system in the coming chapters namely outstanding expense prepaid expense accrued income and unearned income

Consistency

If you are planning to become a finance professional, you will realize that a companies act and income tax act gives us a few flexibility or options while preparing accounts. 

For example

There are two methods of calculating depreciation which was going to study this year. Straight-line method and written down value method. The company can choose what method suits it best. Another example which you are going to study next year. While preparing the capital account apartments can follow 2 methods fixed capital account and fluctuating capital account.

The consistency principle says whenever a company chooses anyone such a method for the next years and the coming future years the company has to be consistent with it and continue using the same method.

So if the company follows the straight-line method in this year and next year changes it to the return down value method it will be in contradiction to the principle of consistency.

Business entity principle

Let me start with an example

Ram and Shyam are two friends who want to open a firm called RS and associates. 

Ram and Shyam are two different beings who have their respective birth certificates driving licenses and Aadhar cards. When both of them registered a firm called RS and associates a new artificial baby is born in the eyes of the law. Rs associate is a new person different from its owners Ram and Shyam. Run associates will have a separate bank account separate address proof and a separate identity. 

The business entity principle explains that a business is a different entity from its owners.

Accounting period concept

As per the income tax act, 1962 and the companies act 2013 all the businesses in India prepare their books of accounts annually starting from the first of April and ending to ending 31st March.

Under the accounting period concept, it becomes important to calculate the profits for a given period in which can be monthly quarterly or annually. Around the World books of accounts are prepared for 12 months that is annually

Cost concept

The cost concept mandates that the acid will appear in the balance sheet on its cost price full stop for example. 

A business purchased a building for 3 lakh rupees and after 10 years the market value has raised reason to 50 lakh. According to the cost, concept acids are recorded in the balance sheet on cost price that is bracket open purchase price closed not the market value. 

What is the cost? 

Cost is considered the purchase price plus all the expenses in curd to bring the acid into using condition. 

For example, we purchase AC for 25000 and to start and make it in a working condition we spend 2000 or the carpenter and 1000 on the transportation charges. As per the cost concept, the cost of the AC is 25000 + 2000 + 10000 which is 28000. In our books, the AC will be recorded on the planting machinery head for 28000. 

Dual aspect principle or double entry principle

In accounts, every transaction happening will have at least two effects that is it will affect at least two accounts.

It is obvious but let us understands with the help of an example

You go to buy a burger at McDonald's now what is happening here you are paying rs 50 to McDonald's and you are getting one burger we are a customer so we have to think from the point of you of the business here the business is McDonald's. The two things happening in this one transaction are one McDonald's is receiving money second McDonald's product the stock is going out. 

In accountancy, everything is recorded on a double-entry system every transaction has two sides

Revenue Recognition Concept.

Let’s take an example:

Our Year of Accounting is from 1 April 2022 to 31 March 2023.  The businessman sold goods worth Rs. 30,000 on 25 march 2023 but it’s a credit sale. The money will be received in the next year on 10 April 2023.

When will you count this sale? In the year 2022-2023 or the year next to that?

As per the revenue Recognition concept and Accrual Assumption. The sale of Rs. 30,000 will be recorded in the year the Sale took Place, not when money is realized.

Matching Concept

How will we calculate the Profit for the year 2022- 2023?

It’s simple. Add all the Revenue and Incomes received in the Current Year (2022-2023) and subtract all the expenses related to generating the Revenue (Business Expenses). 

Why is this an important Accounting Principle? Let’s understand.

Suppose

Rent of Business is Rs. 20,000 p.m. Yearly Rent is Rs. 20,000*12 = Rs. 2,40,000.

Out of this Rs. 40,000 isn’t paid in Cash and is outstanding to be paid in the next year. The accountant did not fully record the Expense as it is not paid and charged only Rs. 2,00,000 in the Current Year (2022-2023).

Do you think that we got the correct profit for the year?

No, we did not. Matching concepts implies that all the revenues earned during one accounting year (whether received or not) have to be matched with the expenses incurred (Paid or outstanding) during the year to calculate the correct profit of that year.

Full Disclosure

As mandated by the Companies Act 2013, every company must disclose all information that is material and relevant to the user of financial statements.  This helps the users to make more informed decisions.

Conservatism Concept (Prudence)

Prudence concept requires that the company should:

1. Account for all losses which are anticipated in the future (even if losses have not been incurred)
2. Account for all gains only when they are realized. (Gains cannot be recorded in the anticipation of gain.)

Materiality Concept

While Accounting the company needs to follow the full disclosure concept but very small transactions for example expense on stationery, pen, and pencils are not material. Even if they are missed in the financial statements, they still give a True picture.

Because the Materiality concept requires that all material facts need to be disclosed.

Objectivity Concept

Accounting is a manmade concept. Entries are made and checked by human beings.  Human beings are not free from Bias.

That is why Accounting requires each transaction to be evidenced by proof or a bill.  Accounting needs to be objective so that the users can fairly rely on the information which is correct and based on facts.