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07 concepts

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WHAT ARE ACCOUNTING CONCEPTS?

These are basic rules, assumptions and principles which act as primary standard for recording business transactions and maintaining uniformity in books of accounts.

Objectives of Accounting concepts

  1. Maintain UNIFORMITY and REGULARITY in preparation of account statements
  2. Principles that help the accountant in preparation and maintenance of business records
  3. Understand business rules and regulations required to be followed by all types of entities

accounting concepts

1. Business Entity Concept

Definition:

  1. The business entity concept states that the business and its owner(s) are separate entities for accounting purposes.
  2. Financial transactions of the business are recorded separately from those of the owners.

Importance:

  • Ensures clarity in financial records by separating personal and business finances.
  • Enhances the accuracy of financial statements.

Example: If an owner invests personal money into the business, it is recorded as a capital contribution to the business. Similarly, any withdrawals made by the owner for personal use are recorded as drawings.

2. Money Measurement Concept

Definition: According to the money measurement concept, only those transactions and events that can be measured in monetary terms are recorded in the accounting books.

Importance:

  • Provides a uniform measurement criterion for financial reporting.
  • Ensures that financial statements reflect quantifiable data.

Example: A company’s goodwill or the efficiency of its employees is not recorded in the financial statements because these cannot be measured in monetary terms. However, the purchase of equipment for Rs 10,000 is recorded because it has a definite monetary value.

3. Going Concern Concept / continuity

Definition: The going concern concept assumes that a business will continue its operations for the foreseeable future and has no intention or necessity to liquidate or significantly scale down .

Importance:

  • Provides a basis for valuing assets and liabilities.
  • Influences the application of accounting policies.

Example: Assets are recorded at cost rather than liquidation value, as the business is expected to use them over time. For instance, a building purchased for Rs 200,000 is recorded at purchase price, not at a potential selling price of Rs 250,000.

4. Cost Concept

Definition: The cost concept states that assets are recorded at their the purchase price and not at their current market value.

Importance:

  • Ensures objectivity and reliability of financial records.
  • Provides a consistent basis for asset valuation.

Example: If a company buys machinery for Rs 50,000, it is recorded at this purchase price, even if its market value changes over time.

5. Realization Concept

Definition: The realization concept dictates that revenue should be recognized and recorded when it is earned, regardless of when the cash is received.

Importance:

  • Ensures that income is matched with the period in which it is earned.
  • Reflects the true performance of a business.

Example: If a company provides services worth Rs 5,000 in December but receives payment in January, the revenue is recorded in December when the services were rendered.

6. Matching Concept

Definition: The matching concept requires that expenses be matched with the revenues they help to generate in the same accounting period.

Importance:

  • Ensures accurate measurement of profit for a specific period.
  • Provides a clear picture of business performance.

Example: If a company incurs Rs 2,000 in advertising expenses in December to generate sales for that month, the expense is recorded in December to match it with the related revenue.

7. Accrual Concept

Definition: The accrual concept states that transactions are recorded when they occur, not when cash is received or paid. This includes recognizing revenues when earned and expenses when incurred.

Importance:

  • Provides a more accurate financial position of the business.
  • Reflects all financial activities within a period.

Example: Interest expense of Rs 1,000 that has accrued but not yet been paid by the end of the year is recorded as an expense for that year, even though the payment will be made in the next year.

8. Conservatism (Prudence) Concept

Definition: The conservatism concept advises that potential expenses and liabilities should be recognized as soon as possible, but revenues should only be recognized when they are assured of being received.

Importance:

  • Prevents overstatement of assets and income.
  • Ensures cautious and realistic financial reporting.

Example: If a company expects a bad debt of Rs 3,000, it should record it as an expense immediately. However, potential income from a lawsuit should only be recorded when it is virtually certain to be won.

9. Consistency Concept

Definition: The consistency concept requires that the same accounting methods and principles be used from period to period, allowing for comparability over time.

Importance:

  • Facilitates comparison of financial statements over different periods.
  • Enhances reliability of financial information.

Example: If a company uses the straight line depreciation method for inventory valuation, it should continue using this method in future periods unless a justified change is made and disclosed.

10. Materiality Concept

Definition: The materiality concept states that all significant items, i.e., items that could influence the decision-making of users, should be disclosed in the financial statements.

Importance:

  • Ensures that financial statements are useful to users.
  • Focuses on significant information, avoiding immaterial details.

Example: A company with total assets of Rs 5 million may not need to separately disclose a Rs 100 expense, but a Rs 50,000 expense would be considered material and should be disclosed.

11. Full Disclosure

Definition:

  1. The full disclosure convention requires that all material information, both financial and non-financial, should be disclosed in the financial statements or notes to the financial statements.
  2. This information should be sufficient to allow users to make informed decisions.

Importance:

  • Transparency: Full disclosure ensures that all relevant information is available to stakeholders, enhancing the transparency of financial statements.
  • Informed Decisions: Users can make better-informed decisions when they have access to all pertinent information.
  • Compliance: It helps in complying with legal and regulatory requirements.

Example:

Significant accounting policies, contingent liabilities, subsequent events, and any changes in accounting methods should be disclosed. For instance, if a company changes its inventory valuation method from FIFO to LIFO, it must disclose this change and its impact on the financial statements.

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