Theory Base of Accounting.

 Basic Accounting Concepts

The basic accounting concepts are referred to as the fundamental ideas or basic

assumptions underlying the theory and practice of financial accounting and

are broad working rules for all accounting activities and developed by the

accounting profession. The important concepts have been listed as below:

• Business entity;

• Money measurement;

• Going concern;

• Accounting period;

• Cost

• Dual aspect (or Duality);

• Revenue recognition (Realisation);

• Matching;

• Full disclosure;

• Consistency;

• Conservatism (Prudence);

• Materiality;

• Objectivity.

1 Business Entity Concept

The concept of business entity assumes that business has a distinct and separate

entity from its owners. It means that for the purposes of accounting, the business

and its owners are to be treated as two separate entities. Keeping this in view,

when a person brings in some money as capital into his business, in accounting

records, it is treated as liability of the business to the owner. Here, one separate

entity (owner) is assumed to be giving money to another distinct entity (business

unit). Similarly, when the owner withdraws any money from the business for his

personal expenses(drawings), it is treated as reduction of the owner’s capital

and consequently a reduction in the liabilities of the business.

The accounting records are made in the book of accounts from the point of view

of the business unit and not that of the owner. The personal assets and liabilities

of the owner are, therefore, not considered while recording and reporting the

assets and liabilities of the business. Similarly, personal transactions of the owner

are not recorded in the books of the business, unless it involves inflow or outflow

of business funds.

2 Money Measurement Concept

The concept of money measurement states that only those transactions and

happenings in an organisation which can be expressed in terms of money

such as sale of goods or payment of expenses or receipt of income, etc., are to be

recorded in the book of accounts. All such transactions or happenings which

can not be expressed in monetary terms, for example, the appointment of a

manager, capabilities of its human resources or creativity of its research

department or image of the organisation among people in general do not find a

place in the accounting records of a firm.

Another important aspect of the concept of money measurement is that the

records of the transactions are to be kept not in the physical units but in the

monetary unit. For example, an organisation may, on a particular day, have a

factory on a piece of land measuring 2 acres, office building containing 10 rooms,

30 personal computers, 30 office chairs and tables, a bank balance of `5 lakh,

raw material weighing 20-tons, and 100 cartons of finished goods. These assets

are expressed in different units, so can not be added to give any meaningful

information about the total worth of business. For accounting purposes,

therefore, these are shown in money terms and recorded in rupees and paise. In

this case, the cost of factory land may be say ` 2 crore; office building ` 1 crore;

computers `15 lakh; office chairs and tables ` 2 lakh; raw material ` 33 lakh

and finished goods ` 4 lakh. Thus, the total assets of the enterprise are valued at

` 3 crore and 59 lakh. Similarly, all transactions are recorded in rupees and

paise as and when they take place.

The money measurement assumption is not free from limitations. Due to the

changes in prices, the value of money does not remain the same over a period of

time. The value of rupee today on account of rise in prices is much less than

what it was, say ten years back. Therefore, in the balance sheet, when we add

different assets bought at different points of time, say building purchased in

1995 for ` 2 crore, and plant purchased in 2005 for ` 1 crore, we are in fact

adding heterogeneous values, which can not be clubbed together. As the change

in the value of money is not reflected in the book of accounts, the accounting

data does not reflect the true and fair view of the affairs of an enterprise.

3 Going Concern Concept

The concept of going concern assumes that a business firm would continue to

carry out its operations indefinitely, i.e. for a fairly long period of time and would

not be liquidated in the foreseeable future. This is an important assumption of

accounting as 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. When we purchase an

asset, for example, a personal computer, for a sum of ` 50,000, what we are

buying really is the services of the computer that we shall be getting over its

estimated life span, say 5 years. It will not be fair to charge the whole amount of

` 50,000, from the revenue of the year in which the asset is purchased. Instead,

that part of the asset which has been consumed or used during a period should

be charged from the revenue of that period. The assumption regarding continuity

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Theory Base of Accounting 27

of business allows us to charge from the revenues of a period only that part of

the asset which has been consumed or used to earn that revenue in that period

and carry forward the remaining amount to the next years, over the estimated

life of the asset. Thus, we may charge ` 10,000 every year for 5 years from the

profit and loss account. In case the continuity assumption is not there, the whole

cost (` 50,000 in the present example) will need to be charged from the revenue

of the year in which the asset was purchased.

4 Accounting Period Concept

Accounting period refers to the span of time at the end of which the financial statements

of an enterprise are prepared, to know whether it has earned profits or incurred

losses during that period and what exactly is the position of its assets and liabilities at

the end of that period. Such information is required by different users at regular

interval for various purposes, as no firm can wait for long to know its financial results

as various decisions are to be taken at regular intervals on the basis of such

information. The financial statements are, therefore, prepared at regular interval,

normally after a period of one year, so that timely information is made available to the

users. This interval of time is called accounting period.

The Companies Act 2013 and the Income Tax Act require that the income

statements should be prepared annually. However, in case of certain

situations, preparation of interim financial statements become necessary.

For example, at the time of retirement of a partner, the accounting period can

be different from twelve months period. Apart from these companies whose

shares are listed on the stock exchange, are required to publish quarterly

results to ascertain the profitability and financial position at the end of every

three months period.

Test Your Understanding - I

Choose the Correct Answer

1. During the life-time of an entity accounting produce financial statements in

accordance with which basic accounting concept:

(a) Conservation

(b) Matching

(c) Accounting period

(d) None of the above

2. When information about two different enterprises have been prepared presented

in a similar manner the information exhibits the characteristic of:

(a) Verifiability

(b) Relevance

(c) Reliability

(d) None of the above

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3. A concept that a business enterprise will not be sold or liquidated in the near

future is known as :

(a) Going concern

(b) Economic entity

(c) Monetary unit

(d) None of the above

4. The primary qualities that make accounting information useful for decision-making

are :

(a) Relevance and freedom from bias

(b) Reliability and comparability

(c) Comparability and consistency

(d) None of the above

5 Cost Concept

The cost concept requires that all assets are recorded in the book of accounts

at their purchase price, which includes cost of acquisition, transportation,

installation and making the asset ready to use. To illustrate, on June 2005, an

old plant was purchased for ` 50 lakh by Shiva Enterprise, which is into the

business of manufacturing detergent powder. An amount of

` 10,000 was spent on transporting the plant to the factory site. In addition,

` 15,000 was spent on repairs for bringing the plant into running position and

` 25,000 on its installation. The total amount at which the plant will be recorded

in the books of account would be the sum of all these, i.e.

` 50,50,000.

The concept of cost is historical in nature as it is something, which has been

paid on the date of acquisition and does not change year after year. For example,

if a building has been purchased by a firm for ` 2.5 crore, the purchase price

will remain the same for all years to come, though its market value may change.

Adoption of historical cost brings in objectivity in recording as the cost of

acquisition is easily verifiable from the purchase documents. The market value

basis, on the other hand, is not reliable as the value of an asset may change

from time to time, making the comparisons between one period to another rather

difficult.

However, an important limitation of the historical cost basis is that it does

not show the true worth of the business and may lead to hidden profits. During

the period of rising prices, the market value or the cost at (which the assets

can be replaced are higher than the value at which these are shown in the

book of accounts) leading to hidden profits.

6 Dual Aspect Concept

Dual aspect is the foundation or basic principle of accounting. It provides the

very basis for recording business transactions into the book of accounts. This

concept states that every transaction has a dual or two-fold effect and should

therefore be recorded at two places. In other words, at least two accounts will be

involved in recording a transaction. This can be explained with the help of an

example. Ram started business by investing in a sum of ` 50,00,000. The

amount of money brought in by Ram will result in an increase in the assets

(cash) of business by ` 50,00,000. At the same time, the owner’s equity or capital

will also increase by an equal amount. It may be seen that the two items that got

affected by this transaction are cash and capital account.

Let us take another example to understand this point further. Suppose the

firm purchase goods worth ` 10,00,000 on cash. This will increase an asset

(stock of goods) on the one hand and reduce another asset (cash) on the other.

Similarly, if the firm purchases a machine worth ` 30,00,000 on credit from

Reliable Industries. This will increase an asset (machinery) on the one hand

and a liability (creditor) on the other. This type of dual effect takes place in

case of all business transactions and is also known as duality principle.

The duality principle is commonly expressed in terms of fundamental

Accounting Equation, which is as follows :

Assets = Liabilities + Capital

In other words, the equation states that the assets of a business are always

equal to the claims of owners and the outsiders. The claims also called equity

of owners is termed as Capital(owners’ equity) and that of outsiders, as

Liabilities(creditors equity). The two-fold effect of each transaction affects in

such a manner that the equality of both sides of equation is maintained.

The two-fold effect in respect of all transactions must be duly recorded in

the book of accounts of the business. 

7 Revenue Recognition (Realisation) Concept

The concept of revenue recognition requires that the revenue for a business

transaction should be included in the accounting records only when it is realised.

Here arises two questions in mind. First, is termed as revenue and the other,

when the revenue is realised. Let us take the first one first. Revenue is the

gross inflow of cash arising from (i) the sale of goods and services by an

enterprise; and (ii) use by others of the enterprise’s resources yielding interest,

royalties and dividends. Secondly, revenue is assumed to be realised when a

legal right to receive it arises, i.e. the point of time when goods have been sold

or service has been rendered. Thus, credit sales are treated as revenue on the

day sales are made and not when money is received from the buyer. As for the

income such as rent, commission, interest, etc. these are recongnised on a

time basis. For example, rent for the month of March 2017, even if received in

April 2017, will be taken into the profit and loss account of the financial year

ending March 31, 2017 and not into financial year beginning with April 2017.

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Similarly, if interest for April 2017 is received in advance in March 2017, it will

be taken to the profit and loss account of the financial year ending

March 2018.

There are some exceptions to this general rule of revenue recognition. In

case of contracts like construction work, which take long time, say 2-3 years to

complete, proportionate amount of revenue, based on the part of contract

completed by the end of the period is treated as realised. Similarly, when goods

are sold on hire purchase, the amount collected in installments is treated as

realised.

8 Matching Concept

The process of ascertaining the amount of profit earned or the loss incurred

during a particular period involves deduction of related expenses from the

revenue earned during that period. The matching concept emphasises exactly

on this aspect. It states that expenses incurred in an accounting period should

be matched with revenues during that period. It follows from this that the

revenue and expenses incurred to earn these revenues must belong to the

same accounting period.

As already stated, revenue is recognised when a sale is complete or service

is rendered rather when cash is received. Similarly, an expense is recognised

not when cash is paid but when an asset or service has been used to generate

revenue. For example, expenses such as salaries, rent, insurance are recognised

on the basis of period to which they relate and not when these are paid. Similarly,

costs like depreciation of fixed asset is divided over the periods during which

the asset is used.

Let us also understand how cost of goods are matched with their sales

revenue. While ascertaining the profit or loss of an accounting year, we should

not take the cost of all the goods produced or purchased during that period

but consider only the cost of goods that have been sold during that year. For

this purpose, the cost of unsold goods should be deducted from the cost of the

goods produced or purchased. You will learn about this aspect in detail in the

chapter on financial statement.

The matching concept, thus, implies that all revenues earned during an

accounting year, whether received during that year, or not and all costs incurred,

whether paid during the year, or not should be taken into account while

ascertaining profit or loss for that year.

9 Full Disclosure Concept

Information provided by financial statements are used by different groups of

people such as investors, lenders, suppliers and others in taking various

financial decisions. In the corporate form of organisation, there is a distinction

between those managing the affairs of the enterprise and those owning it.

Financial statements, however, are the only or basic means of communicating

financial information to all interested parties. It becomes all the more important,

therefore, that the financial statements makes a full, fair and adequate

disclosure of all information which is relevant for taking financial decisions.

The principle of full disclosure requires that all material and relevant facts

concerning financial performance of an enterprise must be fully and completely

disclosed in the financial statements and their accompanying footnotes. This

is to enable the users to make correct assessment about the profitability and

financial soundness of the enterprise and help them to take informed decisions.

To ensure proper disclosure of material accounting information, the Indian

Companies Act 1956 has provided a format for the preparation of profit and

loss account and balance sheet of a company, which needs to be compulsorily

adhered to, for the preparation of these statements. The regulatory bodies like

SEBI, also mandates complete disclosures to be made by the companies, to

give a true and fair view of profitability and the state of affairs.

10 Consistency Concept

The accounting information provided by the financial statements would be

useful in drawing conclusions regarding the working of an enterprise only

when it allows comparisons over a period of time as well as with the working of

other enterprises. Thus, both inter-firm and inter-period comparisons are

required to be made. This can be possible only when accounting policies and

practices followed by enterprises are uniform and are consistent over the period

of time.

To illustrate, an investor wants to know the financial performance of an

enterprise in the current year as compared to that in the previous year. He

may compare this year’s net profit with that in the last year. But, if the

accounting policies adopted, say with respect to depreciation in the two years

are different, the profit figures will not be comparable. Because the method

adopted for the valuation of stock in the past two years is inconsistent. It is,

therefore, important that the concept of consistency is followed in preparation

of financial statements so that the results of two accounting periods are

comparable. Consistency eliminates personal bias and helps in achieving results

that are comparable.

Also the comparison between the financial results of two enterprises would

be meaningful only if same kind of accounting methods and policies are adopted

in the preparation of financial statements.

However, consistency does not prohibit change in accounting policies.

Necessary required changes are fully disclosed by presenting them in the

financial statements indicating their probable effects on the financial results

of business.

11 Conservatism Concept

The concept of conservatism (also called ‘prudence’) provides guidance for recording

transactions in the book of accounts and is based on the policy of playing safe.

The concept states that a conscious approach should be adopted in ascertaining

income so that profits of the enterprise are not overstated. If the profits ascertained

are more than the actual, it may lead to distribution of dividend out of capital,

which is not fair as it will lead to reduction in the capital of the enterprise.

The concept of conservatism requires that profits should not to be recorded

until realised but all losses, even those which may have a remote possibility,

are to be provided for in the books of account. To illustrate, valuing closing

stock at cost or market value whichever is lower; creating provision for doubtful

debts, discount on debtors; writing of intangible assets like goodwill, patents,

etc. from the book of accounts are some of the examples of the application of

the principle of conservatism. Thus, if market value of the goods purchased

has fallen down, the stock will be shown at cost price in the books but if the

market value has gone up, the gain is not to be recorded until the stock is sold.

This approach of providing for the losses but not recognising the gains until

realised is called conservatism approach. This may be reflecting a generally

pessimist attitude adopted by the accountants but is an important way of

dealing with uncertainty and protecting the interests of creditors against an

unwanted distribution of firm’s assets. However, deliberate attempt to

underestimate the value of assets should be discouraged as it will lead to

hidden profits, called secret reserves.

12 Materiality Concept

The concept of materiality requires that accounting should focus on material

facts. Efforts should not be wasted in recording and presenting facts, which

are immaterial in the determination of income. The question that arises here is

what is a material fact. The materiality of a fact depends on its nature and the

amount involved. Any fact would be considered as material if it is reasonably

believed that its knowledge would influence the decision of informed user of

financial statements. For example, money spent on creation of additional

capacity of a theatre would be a material fact as it is going to increase the

future earning capacity of the enterprise. Similarly, information about any

change in the method of depreciation adopted or any liability which is likely to

arise in the near future would be significant information. All such information

about material facts should be disclosed through the financial statements and

the accompanying notes so that users can take informed decisions. In certain

cases, when the amount involved is very small, strict adherence to accounting

principles is not required. For example, stock of erasers, pencils, scales, etc.

are not shown as assets, whatever amount of stationery is bought in an

accounting period is treated as the expense of that period, whether consumed

or not. The amount spent is treated as revenue expenditure and taken to the

profit and loss account of the year in which the expenditure is incurred.

13 Objectivity Concept

The concept of objectivity requires that accounting transaction should be recorded

in an objective manner, free from the bias of accountants and others. This can

be possible when each of the transaction is supported by verifiable documents

or vouchers. For example, the transaction for the purchase of materials may be

supported by the cash receipt for the money paid, if the same is purchased on

cash or copy of invoice and delivery challan, if the same is purchased on credit.

Similarly, receipt for the amount paid for purchase of a machine becomes the

documentary evidence for the cost of machine and provides an objective basis

for verifying this transaction. One of the reasons for the adoption of ‘Historical

Cost’ as the basis of recording accounting transaction is that adherence to the

principle of objectivity is made possible by it. As stated above, the cost actually

paid for an asset can be verified from the documents but it is very difficult to

ascertain the market value of an asset until it is actually sold. Not only that, the

market value may vary from person to person and from place to place, and so

‘objectivity’ cannot be maintained if such value is adopted for accounting

purposes.