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12 ESSENTIAL ACCOUNTING CONCEPTS

December 26, 2018

 

 

Accounting concepts are nothing but a set of assumptions based on which accounting is done. These are widely accepted and followed by organizations uniformly throughout the entire accounting process.

 

Following are the list of those assumptions based on which accounting is done for any enterprise.

 

 

 

1) ENTITY CONCEPT:
 

As per the Entity Concept, Business Organizations and Owners are considered separate. Accounting is done separately for transactions taking place in the Business Organization, which means that the Owner's personal expenses are not mixed up in the business.

 

This concept is applied during the process of accounting, irrespective of the type of Organization say a Private Ltd Company, Partnership or Sole Proprietorship.

 

Care has to be taken by the accountant, especially in the case of Sole Proprietorship to not to mix up the personal accounts and business accounts of the proprietor/ partner/ owner.

 

Sole Proprietors or Partners (in the case of a Partnership Concern) are not advised to take the money which he/ they, has/have invested in the business to his/their personal use often.

 

If some money is taken from the investment, then it is separately shown as drawings.

 

Question: Finger Foods is a Sole Proprietorship Concern. It produces and sells potato chips to its customers. Once, the Owner of finger foods takes his family to a restaurant for a Birthday Party. The restaurant bill comes to Rs.20,000. Can the restaurant bill be included in the accounting books of Finger Foods?

 

Answer: No, the restaurant bill cannot be included in the accounting books of Finger Foods. If in case the owner withdraws money from the Capital (uses his Business Bank Account) he had invested, then the same must be shown as drawings from the Capital and not as an "Expense" in P&L.

It is advised that the owner of Finger Foods, maintain separate Bank Accounts for his own personal use and a separate one for his business.

 

2. MONEY MEASUREMENT CONCEPT

 

As per this concept, only those transactions, which can be measured in terms of money are recorded in accounting books. 

 

Example: Finger Foods Pvt Ltd has promoted Mr. Sharma from Accounts Manager drawing a salary of Rs.70,000 to Director Accounts with a Salary Rs.100,000. Should this be recorded in the accounting books for Finger Foods Pvt Ltd?

 

Answer: No, Promotion of Accounts Manager to Director Accounts will not be included in the Accounting Books. However, the increased salary will be recorded in the books, from the month he is promoted. 

 

Thus any transaction which can be measured in terms of money can only be included in the accounting books. Transactions which cannot be measured in terms of money are excluded, although it might have brought about a significant change in the Organization.

 

We have also touched upon this concept in our previous post - To read it, check out the link below.

 

3. PERIODICITY CONCEPT:

 

The entire life of a Business Organization is broken into chunks to measure its performance. Usually one year. Every year, the performance of the Business Entity, be it a Sole Proprietorship, Partnership or a Company, is evaluated in terms of Profits made, Cashflows generated etc at the end of every year.

 

Accounts are made and finalized every such accounting year. This is called the accounting period.

 

An Organization may draw up accounts from 1st January to 31st December, close the books in December and evaluate performance in December, or, it may draw up accounts from 1st April to 31st March, close the books in March and evaluate the performance in March. Nowadays, almost all entities in India, prepare their book from 1st April to 31st March.

 

By this way, the Organization can

  • Compare the performance of the present year, say 2018 with previous years, say 2017 and 2018.

  • Compare the performance of its own business with its competitors

  • Match the Revenues with Expenses incurred in the period etc.
     

4. ACCRUAL CONCEPT:

 

Under Accrual Concept, the transactions are recognized on Mercantile Basis, that is as and when they occur and not when Cash is paid or received. This is because both may fall on different timelines.

 

Example: A Sale might have happened in the year 2017, say November 2017, but cash might have been received only on January 2018. Thus Revenue is recognized in the period 2017 and not 2018 (when the cash is received).

 

We have discussed the Accrual Concept in Depth in a separate post. Check out this link for more detailed explanation, with examples, on Accrual Concept.

 

5. MATCHING CONCEPT
 

Under the Matching Concept, all revenues and expenses are to be matched in the period in which they are incurred.
 

 

 

Thus if you notice in the above example, only the expense or cost relating to the revenue is matched to arrive at the profit. It is incorrect to include  the cost of entire 10,000 pcs of leather bought. 

 

6. GOING CONCERN CONCEPT
 

While preparing the Financial Statement, the accountant assumes that the entity will be a Going Concern, that is, will operate and continue operating in the future. It is only based on this concept that the assets are valued at historical cost and depreciation and amortization are computed.

 

To further explain this concept of valuing assets on historical cost, it is important to note that the assets shown in the balance sheet are shown at cost at which the assets were bought originally. The Company might have bought and asset 2 years, 4 years or 6 years back, yet it is carried in the Balance Sheet at cost every single year after that. The Company's accountant does not stop to check the current value of the asset at the end of each year, because he assumes that the entity is a Going Concern.

 

7. COST CONCEPT
 

In this concept, the assets are valued at historical cost and not the present value. It is almost not practical to keep reviewing the value of assets at the end of each financial year. 
 

Example: If a Machinery was purchased for Rs.10 Lakhs in the year 2005, the asset has to be shown at Rs.10 Lakhs only in the Balance Sheet.

 

However, there are few exceptions to this cost concept, which will be discussed in later posts.

 

8. REALISATION CONCEPT
 

The realisation concept states that, whenever there is a change in the value of the Fixed Asset, which is permanent in nature, then the asset is carried at such changed value in the Balance Sheet

 

9. DUAL ASPECT CONCEPT
 

According to this concept, every transaction increases/ decreases the value of an asset and simultaneously increases or decreases the value of a liability.

 

Hence as per this concept, every single transaction, which can be measured, does one of the following.

 

a) Increases the value of an Asset and simultaneously Decreases the value of another Asset.

 

Example: Machinery bought for Rs.100,000 by paying cash upfront. In this case, Machinery is increased, by Rs.100,000 and simultaneously, the Cash balance is reduced by Rs.100,000.

 

b) Increases the value of an Asset and simultaneously Increases the value of a Liability.
 

Example: Machinery bought for Rs.100,000 from X Ltd, repayment to be made later to X Ltd. In this case, Machinery is increased by Rs.100,000 and creditor increased by Rs.100,000. Increase in creditor is the increase in Liability.

 

Similarly, you can take any transaction and notice an increase or decrease in asset and its simultaneous increase or decrease in asset or liability.

 

This develops the Accounting Equation

 

Equity (E) + Liability (L) = Asset (A)

 

10. CONCEPT OF CONSERVATISM
 

According to this concept, an Accountant should adopt a conservative approach in accounting for transactions. While he is expected to provide for all possible losses in the business and take them into consideration while accounting, he is not expected to account for gains which are not realized or which is not likely to occur in the future with a certainty.

 

Creating a provision for bad and doubtful debts is a classic example, where the accountant exercises conservatism. He is expected to be prudent and account for all possible losses, so that the business is safeguarded against surprise losses which may occur in the future. Hence, he is expected to foresee such events and provide for it in the books.

 

11. CONSISTENCY
 

If an accountant decides to adopt an accounting policy for one accounting year, he is expected to follow the same policy year after year.
 

For Example: If an accountant chooses to follow written down value method of depreciation, he is expected to stick to it in later years and is not expected to change the method of depreciation, unless otherwise there arises a situation which strongly necessitates the change in method.
 

Following are the 3 situations in which an accountant is allowed to change the accounting policy.

  • To bring the books of accounts in accordance with the issued accounting standards

  • To comply with the provisions of the law

  • When it is felt that the changed accounting policy would reflect a more true and fair view of the Company's financial statement.

12. MATERIALITY
 

According to the concept of materiality, all items which are not so significant in value are ignored during the process of accounting as it will not be relevant to the users of the Financial Statements. It is purely left to the accountant's judgement as to which item is material and which is immaterial. Any item which impacts the business significantly is only to be considered and other insignificant items are to be ignored.

 

For any further questions contact therankholder@gmail.com

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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