acccounting concepts and principles

Basic accounting concepts
(1) Business entity concepts
This concept assumes that business has a distinct and separate entity from its owners.
Therefore business transactions are recorded in the books of accounts from the business point
of view and not owners. For example, If owner bring Rs. 1,00,000 as capital in business. It is
treated as liability of business to owner. Similarly if owner withdrew Rs. 5,000 from business
for personal use, it is treated as reduction of owner‟s capital and consequently reduction in
liability of business towards owner.
(2)Money measurement concept
This concept states that transactions and events that can be expressed in money terms are
recorded in the books of accounts. Non monetary transactions cannot be recorded in the books
like appointment of manager, capabilities of human resources etc.
Another aspect is the records of transactions are to be kept not in physical unit but in
monetary unit. For example, an organisation has 2 buildings, 15 computers, 20 office tables
are not recorded because they are physical unit and not in monetary unit.
Limitation of this concept is the value of rupee does not remain same over a period of time.
As changes in the value of money is not reflected in books does not reflect fair view of
business affairs.
(3) Going concern concept
This concept assumes that business shall continue to carry out its operations indefinitely for a
long period of time and would not be liquidated in the foreseeable future. It provides the very
basis for showing the value of assets in the balance sheet.
An asset may be defined as a bundle of services. For example, a machine purchased for Rs.
2,00,000 and its estimated useful life say 10 years. The cost of machinery is spread on
suitable basis over next 10 years for ascertaining the profit or loss for each year. The total cost
of the machine is not treated as an expense in the year of purchase itself.
(4) Accounting period concept
Accounting period refers to span of time at the end of which financial statements are prepared
to know the profits or loss and financial position of business. Information is required to by
different users at regular intervals for decision making. For example, bankers require
information periodically because they want to ensure safety and returns of their investments.
Similarly management requires information at regular interval to assess the performance and
funds requirement. Therefore they are prepared at regular interval, normally a period of one
year. This interval of time is called accounting period.
(5) Cost concept
According to this concept all assets are recorded in the books of accounts at the purchase
price which includes the purchase price, cost of acquisition, transportation and installation.
For example, if an asset purchased for Rs. 1,00,000 and spent Rs. 10,000 on its installation.
Therefore asset will be recorded in the books of accounts at Rs. 1,10,000.
This concept is historical in nature. For example, if machine purchased for Rs. 75,000, the
purchase or acquisition price will remain same for all years to come, though its market value
may change. The main limitation of this concept is that it does not show the true value of
asset and may lead to hidden profits.
(6) Dual aspect concept
This concept provides the very basis for recording the transaction in the books of accounts. It
states that every transaction entered in the books has two aspects. For example, Man as started
business with cash Rs. 50,000. In this transaction asset (cash) increases and liability (capital
of owner) also increases. This principle is also known as duality principle. This principle is
commonly expressed in fundamental accounting equation given below.
Assets = Liabilities + Capital
This equation states that assets of business are always equal to the claims of owners and
(7) Revenue recognition concept ( Realisation concept)
According to this principle revenue is considered to have been realised when a transaction has
been entered and obligation to receive the amount has been established. In other words when
we receive right to receive revenue than it is called revenue is realised. For example, sales
made in March, 2010 and receives amount in April, 2010. Revenue of these sales should be
recognised in February month, when the goods sold. For example commission for the March,
2010 even if received in April 2010 will be taken into profit and loss A/c of March, 2010.
Similarly if rent for the April, 2010 is received in advance in March, 2010 it will be taken the
profit and loss A/c of the financial year of March, 2011.
(8) Matching concept
The matching concept states that expense incurred in an accounting period should be matched
with revenues during that period. It follows from this that revenue and expenses incurred to
earn these revenues must belong to the same accounting period.
For example, salary for the month of March, 2010 paid in April, 2010 is recorded in the profit
and loss A/c of financial year ending March, 2010 and not in the year when it realized.
Similarly we records cost of goods sold and not the goods purchased or produced. So the cost
of unsold goods should be deducted from the cost of goods produced or purchased.
(9) Full disclosure concept
Apart from legal requirement good accounting practice require all material and significant
information must be disclosed. Financial statements are the basic means of communicating
financial information to its users for taking useful financial decisions. This concept states that
all material and relevant fact and financial performance must be fully disclosed in financial
statement of the business. Company‟s act 1956 has provided a format for making profit and
loss A/c and balance sheet, which needs to be compulsorily adhered to for preparation of
financial statement. Disclosure of material information results in better understanding. For
example, the reasons for low turnover should be disclosed.
(10)Consistency concept
This concept states that accounting practices followed by an enterprise should be uniform and
consistent over a period of time. For example if an enterprise has adopted straight line method
of charging depreciation then it has to be followed year after year. If we adopt written down
value method from second year for charging depreciation than the financial information will
not be comparable. Consistency eliminates the personal bias helps in achieving the results that
are comparable. However consistency does not prohibits the change accounting policies.
Necessary changes can be adopted and should be disclosed.
(11) Conservatism concept (Prudence concept)
This concept takes into consideration all prospective losses but not the prospective profit. It
means profit should not be recorded until it realised but all losses, even those which have
remote possibility are to be recorded in the books. For example, valuing closing stock at cost
or market value whichever is lower, creating provision for doubtful debts etc. This concept
ensures that the financial statements provide the real picture of the enterprise.
(12) Materiality concept
This concept states that accounting should focus on material fact. Whether the item is material
or not shall depend upon nature and amount involved in it. For example, amount spent of
repair of building Rs. 4,00,000 is material for enterprise having the sales turnover of
Rs.1,50,000 but not material for enterprise having turnover of Rs. 25,00,000. Similarly
closure of one plant material but stock eraser and pencils are not shown at the asset side but
treated as expenses of that period, whether consumed or not because the amount involved in it
are low.
(13) Objectivity concept
This concept states that accounting should be free from personal bias. This can be possible
when every transaction is supported by verifiable documents. For example, purchase of
machinery for Rs. 30,000 should be supported by the voucher and should be recorded in the books of accounts. Similarly other supporting documents are cash memo, invoices, receipts
provides the basis for accounting and auditing.
Basis of Accounting:
(1) Cash basis
Under this entries in the books of accounts are made when cash id received or paid and not
when the receipt or payment becomes due. For example, if salary Rs. 7,000 of January 2010
paid in February 2010 it would be recorded in the books of accounts only in February, 2010.
(2) Accrual basis
Under this however, revenues and costs are recognized in the period in which they occur
rather when they are paid. It means it record the effect of transaction is taken into book in the
when they are earned rather than in the period in which cash is actually received or paid by
the enterprise. It is more appropriate basis for calculation of profits as expenses are matched
against revenue earned in the relation thereto. For example, raw materials consumed are
matched against the cost of goods sold for the accounting period.
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2.1.1 Accounting Entity Assumption
According to this assumption, business is treated as a unit or entity
apart from its owners, creditors and others. In other words, the
proprietor of a business concern is always considered to be separate
and distinct from the business which he controls. All the business
transactions are recorded in the books of accounts from the view point
of the business. Even the proprietor is treated as a creditor to the
extent of his capital.
2.1.2 Money Measurement Assumption
In accounting, only those business transactions and events which
are of financial nature are recorded. For example, when Sales Manager
is not on good terms with Production Manager, the business is bound
to suffer. This fact will not be recorded, because it cannot be measured
in terms of money.
2.1.3 Accounting Period Assumption
The users of financial statements need periodical reports to know
the operational result and the financial position of the business concern.
Hence it becomes necessary to close the accounts at regular intervals.
Usually a period of 365 days or 52 weeks or 1 year is considered as
the accounting period.
2.1.4 Going Concern Assumption
As per this assumption, the business will exist for a long period
and transactions are recorded from this point of view. There is neither
the intention nor the necessity to wind up the business in the foreseeable
2.2 Basic Concepts of Accounting
These concepts guide how business transactions are reported.
On the basis of the above four assumptions the following concepts
(principles) of accounting have been developed.
2.2.1 Dual Aspect Concept
Dual aspect principle is the basis for Double Entry System of
book-keeping. All business transactions recorded in accounts have two
aspects - receiving benefit and giving benefit. For example, when a
business acquires an asset (receiving of benefit) it must pay cash (giving
of benefit).
2.2.2 Revenue Realisation Concept
According to this concept, revenue is considered as the income
earned on the date when it is realised. Unearned or unrealised revenue
should not be taken into account. The realisation concept is vital for
determining income pertaining to an accounting period. It avoids the
possibility of inflating incomes and profits.
2.2.3 Historical Cost Concept
Under this concept, assets are recorded at the price paid to acquire
them and this cost is the basis for all subsequent accounting for the
asset. For example, if a piece of land is purchased for Rs.5,00,000 and
its market value is Rs.8,00,000 at the time of preparing final accounts
the land value is recorded only for Rs.5,00,000. Thus, the balance
sheet does not indicate the price at which the asset could be sold for.
2.2.4 Matching Concept
Matching the revenues earned during an accounting period with
the cost associated with the period to ascertain the result of the business
concern is called the matching concept. It is the basis for finding accurate
profit for a period which can be safely distributed to the owners.
2.2.5 Full Disclosure Concept
Accounting statements should disclose fully and completely all the
significant information. Based on this, decisions can be taken by various
interested parties. It involves proper classification and explanations of
accounting information which are published in the financial statements.
2.2.6 Verifiable and Objective Evidence Concept
This principle requires that each recorded business transactions in
the books of accounts should have an adequate evidence to support it.
For example, cash receipt for payments made. The documentary
evidence of transactions should be free from any bias. As accounting
records are based on documentary evidence which are capable of
verification, it is universally acceptable.
2.3 Modifying Principles
To make the accounting information useful to various interested
parties, the basic assumptions and concepts discussed earlier have been
modified. These modifying principles are as under.
2.3.1 Cost Benefit Principle
This modifying principle states that the cost of applying a principle
should not be more than the benefit derived from it. If the cost is more
than the benefit then that principle should be modified.
2.3.2 Materiality Principle
The materiality principle requires all relatively relevant information
should be disclosed in the financial statements. Unimportant and
immaterial information are either left out or merged with other items.
2.3.3 Consistency Principle
The aim of consistency principle is to preserve the comparability
of financial statements. The rules, practices, concepts and principles
used in accounting should be continuously observed and applied year
after year. Comparisons of financial results of the business among
different accounting period can be significant and meaningful only when
consistent practices were followed in ascertaining them. For example,
depreciation of assets can be provided under different methods,
whichever method is followed, it should be followed regularly.
2.3.4 Prudence (Conservatism) Principle
Prudence principle takes into consideration all prospective losses
but leaves all prospective profits. The essence of this principle is
“anticipate no profit and provide for all possible losses”. For example,
while valuing stock in trade, market price or cost price whichever is
less is considered.
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1. Dual Aspect
2. Revenue Realisation
3. Historical Cost
4. Matching
5. Full Disclosure
6. Verifiable and
objective evidence
1. Accounting Entity
2. Money Measurement
3. Accounting Period
4. Going Concern
Modifying Principles
1. Cost Benefit
2. Materiality
3. Consistency
4. Prudence
Frame Work of Accounting
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