The fundamental ideas or basic concepts of accounting underlying the theory and practice of financial accounting and broad working rules for all accounting activities, developed by professionals are listed and discussed below.
9 Basic Accounting Concepts
- Business Entity Concept
- Money Measurement Concept
- Going Concern Concept
- Accounting Period Concept
- Dual Aspect (or Duality) Concept
- Cost Concept
- Matching Concept
- Accrual Concept
- Realisation Concept
Table of Contents
These concepts are the foundation of systematic and proper accounting. Every business enterprise must adopt these concepts, popularly known as pillars upon which the sound structure of accounting stands. Let us discuss these basic concepts:
Business Entity Concept
In accounts, we distinguish between the business and its proprietors. Business is assumed to have distinct entity i.e., existence other than the existence of its proprietors and other business units. As an accountant, we are concerned with the business not the businessman.
We have to record business transactions from firm’s point of view and never from the viewpoint of proprietors. We record transactions in the books of shop, establishment, factory, firm, company and enterprise and never in the books of proprietor, partners and shareholders. While making decisions regarding asset, liability, capital, revenue and expense, business viewpoint is taken into consideration.
The capital introduced by the proprietor in its own business is considered liability from business point of view. It will not be a liability if proprietor’s viewpoint is taken. The logic behind treatment of capital as liability is that the firm has borrowed funds from its own proprietors instead of borrowing it from outside parties.
It would have been a liability if the funds would have been borrowed from outside agency, then why not, if it is being invested by the proprietor himself. We also allow interest on capital to the proprietors because capital is supposed to be a liability.
Interest on capital is an expense of the business, therefore, it will reduce the profit of the firm. It is at the same time proprietor’s claim against the business, so it will increase him capital. Amount withdrawn by the proprietor for personal use, known as drawings is assumed to be the assets of the business and at the same time a liability to the proprietor.
The business as a distinct entity records all business transaction into the books of accounts and reports the result to the proprietor in case of sole trade, partners in case of partnership firms and shareholders in case of company. There is a legal divorce between the ownership and management of a company.
The company is owned by shareholders by managed by the elected representatives of the shareholders i.e., directors. Accounts are prepared by the management and a copy of the financial statements is supplied to the shareholders, the owners of the company for information. Every accountant whether he is concerned with a petty shop or a firm or a company or a big business house will have to compulsorily adopt the concept of business entity in his accounting operations.
Legally, a sole proprietor or the partner of a partnership firm are not separate from their business units but in Accounting the business units are assumed to have distinct entity. Accounting entity is different from business entity. Accounting entity is wider term including business, clubs, institutions, public enterprises, local bodies and government, etc.
Money Measurement Concept
In accounting, we identify and record only those business transactions which are financial in nature. Accounting transactions must have their monetary value. The worth of the transaction must be measured in terms of money. In all the accounting records, we have amount column showing rupees and paise.
There is never any accounting record in metres, litres, kilograms and quintals. We evaluate the value of the commodities in terms of money and accordingly record them in the books of accounts. Recording transactions in monetary terms makes the information more meaningful.
For example, statement that the business was started with Rs. 50,000 cash and 20,000 metres of silk is meaningless and fails to tell us the capital of the business. If the value of 20,000 metres of silk is estimated to be Rs. 5,00,000, we can safely say that the business was started with Rs. 50,000 + 5,00,000 = 5,50,000, which will be meaningful.
The concept of money measurement is not free from problems when we integrate the financial statements of an entity having operations in more than one nation.
Going Concern Concept
While recording business transactions in the books of accounts, we assume that the business will be carried on indefinitely. That is why, the business purchases fixed assets like land and building, plant and machinery, vehicles, furniture, etc.
If the concept of going concern is not there, we would have hired these assets and not purchased. These assets have been acquired for use and not for sale, so we maintain individual assets account and charge necessary depreciation on it.
According to International Accounting Standard “The enterprise is normally viewed as a going concern, that is as continuing in operation for the foreseable future”.
It is viewed that the enterprise has an intention to be carried on for longer period. The concept of assets, liabilities, capital, revenue and expenses used in the accounting operation prove that the firm has to last long. Planning, organizing and personnel policies substantiate the fact that the business has been assumed to be going entity. It is binding upon every accountant to treat business activity as a continuing process and record transaction accordingly.
Accounting Period Concept
Strictly speaking, the result of the business can be estimated at the end of its life. If a firm was started with a capital of 50,000 and at the end of its life the capital was 5,00,000 we can say that the firm earned a profit of 4,50,000 i.e., 5,00,000 – 50,000 during its life.
In this way, business as a going entity will continue indefinitely and we will have to wait for a very long period to estimate the financial result of the business. It will be too late to wait for the results, so the life span of accounting should be split into shorter and convenient period. At present, accounting periods are regarded as twelve months.
According to the Companies Act and Banking Regulation Act, accounting period should consist of twelve months. The period of twelve months is regarded as ideal and convenient period for accounting.
Dual Aspect (or Duality) Concept
Every business transaction has double effect. There are two sides of every transaction. This is evident when we study the accounting term i.e., assets, capital and liabilities.
- Assets: These are the valuable articles owned by the business. Expenditure incurred in acquiring valuable things for the firm is assets. Special features of assets are that they are meant for use in the business and will increase the profit earning capacity of the business.
Cash in hand, cash at bank, land and buildings, furniture, vehicles, etc. are the assets of the firm. It has been an established fact that no business can be carried on without assets. Business as a separate entity and going concern must possess certain assets.
- Capital: Capital is that part of wealth which is used for further production. In the context of dual aspect concept capital supplies necessary funds to the business to purchase certain assets. In the absence of capital, there will be no funds with the enterprise and thus the question of acquiring assets does not arise. If we take it from business point of view, proprietor’s capital is the liability of the business.
Capital received in cash represents two accounts, capital and cash. Capital is the proprietor’s claim against the assets of the business and the cash is the asset of the business itself. As the amount of the two accounts are the same, we can safely conclude that: Capital = Assets
- Liabilities: If the capital invested by the proprietor falls short the business has to borrow funds. Thus the loan on the one side is the liability of the firm and on the other side it will be in the form of cash or other assets. The amount represented by both loan and assets are equal. This transaction enables us to think about the two aspects so it is called dual aspect concept or double entry system.
All the assets of the business are acquired by the funds contributed by the funds contributed by the proprietors and creditors, so it is always correct to conclude as under: Capital = Liabilities = Assets
The relationship between assets, liabilities and capital is at present known as Accounting Equation which can also be expressed as under :
Assets = Capital + Liabilities
Capital = Assets – Liabilities
Liabilities = Assets – Capital
We record all the business transactions on the basis of dual aspect and call the system as double entry system.
The term ‘assets’ denotes the resources land building, machinery etc. owned by a business. The money values that are assigned to assets are derived from the cost concept. According to this concept an asset is ordinarily entered on the accounting records at the price paid to acquire it.
For example, if a business buys a plant for Rs. 5 lakh the asset would be recorded in the books at Rs. 5 lakh, even if its market value at that time happens to be Rs. 6 lakh.
Thus, assets are recorded at their original purchase price and this cost is the basis for all subsequent accounting for the business. The assets shown in the financial statements do not necessarily indicate their present market values. The term ‘book value’ is used for the amount shown in the accounting records.
The cost concept does not mean that all assets remain on the accounting records at their original cost for all times to come. The asset may systematically be reduced in its value by charging ‘depreciation’, which will be discussed in detail in a subsequent lesson. Depreciation has the effect of reducing profit of each period.
The prime purpose of depreciation is to allocate the cost of an asset over its useful life and not to adjust its cost. However, a balance sheet based on this concept can be very misleading as it shows assets at a cost even when there are a wide difference between their costs and market values. Despite this limitation, you will find that the cost concept meets all the three basic norms of relevance, objectivity and feasibility.
This concept is based on the accounting period concept. In reality we match revenues and expenses during the accounting periods. Matching is the entire process of periodic earnings measurement, often described as a process of matching expenses with revenues. In other words, income made by the enterprise during a period can be measured only when the revenue earned during a period is compared with the expenditure incurred for earning that revenue.
Broadly speaking revenue is the total amount realized from the sale of goods or provision of services together with earnings from interest, dividend, and other items of income. Expenses are cost incurred in connection with the earnings of revenues. Costs incurred do not become expenses until the goods or services in question are exchanged.
Cost is not synonymous with expense since expense is a sacrifice made, resource consumed in relation to revenues earned during an accounting period. Only costs that have expired during an accounting period are considered as expenses.
For example, if a commission is paid in January, 2002, for services enjoyed in November, 2001, that commission should be taken as the cost for services rendered in November 2001. On account of this concept, adjustments are made for all prepaid expenses, outstanding expenses, accrued income, etc, while preparing periodic reports.
It is generally accepted in accounting that the basis of reporting income is accrual. Accrual concept makes a distinction between the receipt of cash and the right to receive it, and the payment of cash and the legal obligation to pay it. This concept provides a guideline to the accountant as to how he should treat the cash receipts and the right related thereto.
Accrual principle tries to evaluate every transaction in terms of its impact on the owner’s equity. The essence of the accrual concept is that net income arises from events that change the owner’s equity in a specified period and that these are not necessarily the same as change in the cash position of the business. Thus it helps in proper measurement of income.
Realisation is technically understood as the process of converting non-cash resources and rights into money. As accounting principle, it is used to identify precisely the amount of revenue to be recognised and the amount of expense to be matched to such revenue for the purpose of income measurement.
According to realisation concept revenue is recognized when sale is made. Sale is considered to be made at the point when the property in goods passes to the buyer and he becomes legally liable to pay. This implies that revenue is generally realised when goods are delivered or services are rendered. The rationale is that delivery validates a claim against the customer. However, in case of long run construction contracts revenue is often recognised on the basis of a proportionate or partial completion method.
Similarly, in case of long-run instalment sales contracts, revenue is regarded as realised only in proportion to the actual cash collection. In fact, both these cases are exceptions to the notion that an exchange is needed to justify the realisation of revenue.