Home page               Download material                Accounting topics                Accounting dictionary                Financial calculators

Home Introduction to Accounting Accounting Concepts

Accounting Concepts:

New Page 2
The term ' accounting concepts' includes those basic assumptions or conditions on which the science of accounting is based. These concepts are used by accountants and bookkeepers all over the world.

Following are the most important accounting concepts:

  1. Separate entity concept.
  2. Going concern concept.
  3. Money measurement concept.
  4. Cost concept.
  5. Dual aspect concept.
  6. Accounting period concept.
  7. Matching concept.
  8. realization concept.

These accounting concepts are explained below:

1. Separate Entity Concept:

Accounts are kept for entities, as distinguished from the persons who are associated with these entities. In recording events in accounting, the important question is: "How do these events affect the entity?" How they affect the persons who own, operate, or otherwise are associated with the entity is irrelevant. For example, when a person invests $200,000 into business it will be deemed that the owner has given that money to the business which will be shown as a 'liability' in the books of the business. In case the owner withdraws $30,000 from the business, it will change the position and the net amount payable by the business to the owner will be shown only as $170,000.

The concept of separate entity is applicable to all forms of business organizations. For example, in case of a sole proprietorship or partnership business, though the sole proprietor or partners are not considered as separate entities in the eyes of law, but for accounting purposes they will be considered as separate entities.

2. Going Concern Concept:

According to this concept it is assumed that an entity is a going concern - that it will continue to operate for an indefinite time period there is no intention to liquidate the particular business venture in the foreseeable future. On account of this concept, the accountant while valuing the asset does not take into account the sale value of assets. Moreover, he charges depreciation on fixed assets on the basis of their expected life rather than on their market values.

For example, suppose that a company has just purchased a three-year insurance policy for $45,000. If we assume that the business will continue in operation for three years or more. We will consider the $45,000 cost of insurance as an asset which provides services to the business over a three-year period. On the other hand, if we assume that the business is likely to terminate in the near future, the insurance policy should be reported at its cancellation value i.e. the amount refundable upon cancellation.

Moreover, the concept applies to the business as a whole. When an enterprise liquidates a branch or one segment of its operations, the ability of the enterprise to continue as a going-concern is not impaired normally. The enterprise will not be considered as a going-concern when it has gone into liquidation.

3. Money Measurement Concept:

In financial accounting, a record is made only of those information that can be expressed in monetary terms. In other words, no accounting is possible for an event or transaction which is not measurable in terms of money, e.g. passing an examination, delivering lecture in a meeting, winning a prize etc. These are events no doubt, but since these are not measurable in terms of money, there is no question of their accounting.

Measurement of business events in money helps in understanding the state of affairs of business in a much better way. For example, If a business owns. 1,500kg of stock, one car, 1,500 square feet of building space etc. these amounts cannot be added to produce a meaningful total of what the business owns. However, if these items are expressed in monetary terms such as stock $24,000, car $300,000 and building $500,000, all such items can be added in better way and precise estimate about the assets of the business will be available.

4. Cost Concept:

The concept is closely related to going concern concept. According to this concept. "An asset is ordinarily entered on the accounting record at the price paid to acquire it, and this cost is the basis for all subsequent accounting for the asset". If business buys a building for $5,00,000, the assets would be recorded in the books at $500,000, even if its market value at that time may be $550,000. In case a year later the market value of this asset comes down to $450,000 it will ordinarily continue to be shown at $500,000 and not at $450,000.

The cost concept does not mean that the asset will always be shown at cost. It has also been stated above that cost becomes the basis for all future accounting for the asset. It means that asset is recorded at cost at the time of purchase but it may systematically be reduced in its value by charging depreciation.

5. Dual Aspect Concept:

The economic resources of an entity are called 'assets'. The claims of various parties against these assets are called 'equities'. There are two types of equities:

  1. Liabilities, which are the claims of creditors (that is, everyone other than the owners of business) and
  2. Owner's Equity, which is the claim of the owners of the business.

Since all of the assets of a business are claimed by someone (either by its owners or by its creditors) so we can say that

Assets = Equities

This is the fundamental accounting equation, which is the formal expression of the dual - aspect concept. As we shall see all accounting procedures are derived from this equation. To reflect the two type of equities, the equation is more commonly expressed as:

Assets = Liabilities + Owner's Equity

Every transaction has a dual impact on the accounting records. Accounting systems are set up so as to record both of these aspects of a transaction; this is why accounting is called a double-entry system.

To illustrate the dual-aspect concept, suppose that Mr. A starts a business with a capital of $30,000. There are two changes, first the business has cash (asset) of $30,000 and second, the business has to pay to the proprietor a sum of $10,000 which is taken as proprietor's capital. This expression can be shown in the form of following equation:

Cash (Assets) = Capital (Equities) $30,000 = $30,000.

Subsequently if the business borrows $15,000 from a bank, the new position would be as follows:

Assets = Equities

Cash $30,000 + Bank $15,000 = Bank loan $15,000 + Capital $30,000.

The term 'accounting equation' is also used to denote the relationship of equities to assets. The equation can be technically, stated as "for every debit, there is an equivalent credit".

6. Accounting Period Concept:

The users of financial statements need information that is reasonably current. Therefore, for financial reporting purposes, the life of a business is divided into a series of relatively short accounting periods of equal length. It is, therefore, absolutely necessary that after each accounting period the business must 'stop' and 'see back', how things are going. In accounting such accounting period is usually of a year.

At the end of each accounting period an income statement and a balance sheet is prepared the income statement discloses the profit or loss made by business during the year while balance sheet shows the financial position of business as on the last day of the accounting period.

7. The Matching Concept:

A significant relationship exists between revenue and expenses. Expenses are incurred for the purpose of producing revenue. In measuring net income for a period, revenue should be offset by all the expenses incurred in producing that revenue. This concept of offsetting expenses against revenue on the basis of "cause and effect" is called the Matching Concept.

The term 'matching' means appropriate association of related revenues and expenses. In matching expenses against revenue the question when the payment was made or received is 'irrelevant'. For example if a salesman is paid commission in January, 2005, for sales made by him in December, 2004. According to this concept commission expense should be offset against sales of December 2004 because this expense is incurred for producing revenue in December 2004. On account of this concept, adjustments are made for all outstanding expenses, accrued revenues, prepaid expenses and unearned revenues, etc., while preparing the final accounts at the end of accounting period.

8. Realization Concept:

Accounting to this concept revenue should be recognized at the time when goods are sold or services are rendered. 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. The following example will help to understand this point. Mr. A places an order to Mr. B for supply of certain goods. Mr. B sends goods to Mr. A 15 days after he has received the order and Mr. A makes payment 10 days after receipt of goods. In this case the sale will be presumed to have been made not at the time of receipt of the order for the goods or receipt of payment but at the time when goods are delivered to Mr. A.

New Page 2

More study material from this topic:

Need and importance of accounting
Accounting as a business language
Bookkeeping versus accounting
Branches of accounting
Objects of accounting
Important accounting terms and concepts
Accounting principles
Accounting concepts
Accounting conventions
Questions and answers



Home                         Download material                         Contact us                         Privacy policy                         Link to us                         Advertise

Copyright 2011