The following points highlight the ten major types of accounting concepts. The ten concepts are: 1. Business Entity Concept 2. Going Concern Concept 3. Money Measurement Concept (Monetary Expression) 4. Cost Concept 5. Accounting Period Concept 6. Dual Aspect Concept 7. Matching Concept 8. Realisation Concept 9. Balance Sheet Equation Concept 10. Verifiable and Objective Evidence Concept.
Under this concept, it is assumed that the business unit is distinct and completely separate from its owners (including employees, officers, creditors and others who are associated with it).
For accounting purposes, the business enterprise exists in its own right.
As a result, transactions should be recorded in the books of accounts with such persons and individuals together with the owners. It becomes necessary that accounting records of the business must be maintained in a manner which is free from any bias to any particular section of people related to it.
As such, accounts are maintained for business entity as distinguished from all categories of persons related to it. For recording transactions the pertinent question which arises is: How far such transactions affect the business itself, and not: How do they affect the people associated with it.
When the owner introduces cash to the business as capital, it simply means an inflow of cash to the business which is recorded in business books. But actually, to an owner, it is a shift from the personal cash to the business cash.
However, some practical difficulties may arise by defining a business entity for which accounts are kept, specially in case of sole proprietorship and partnership business, and that of the people who own it. That is, a sole trader is personally liable for his business debts and may be required to use non-business (Personal) assets in order to pay-off the business debts. On the contrary, business assets of the Sole-Proprietor may be utilised for paying-off the personal obligation of the Proprietor, i.e., in the eye of law, business and non-business (Personal) assets and liabilities are treated alike in the case of a Sole-Proprietor.
Same principle is, however, applicable in case of a partnership firm, i.e., after paying- off the business liabilities, if any surplus remains, the same can also be used in order to pay-off the personal obligation of the partners. In case of a company, however, the entity of the business is legally separated from that of the owners. The application of the concept becomes relatively easier in this case.
Practical difficulties arise by identifying business affairs of a group of companies under common management. Thus, if eight companies, under the same management, utilise common services like accommodation, office and administration service etc., the problem of allocation of such common services among all the eight companies would not be an easy task. Besides, at its initial stage, accounting had the basic stewardship function.
Consequently, the manager of the firm was supplied with the necessary funds by the owners and the lenders. It was the duty of the management to utilise such funds properly and the reports of the financial accounting were designed to project how best the management discharged this stewardship function. The origin of this concept can be traced from this stewardship function.
Thus, accounting to this concept, suggested that the affairs of the business must not be mixed up with the private affairs of owners or other persons associated with it. As such, this concept helps to give a true picture of the financial conditions of a business enterprise.
This concept assumes that the business entity has a continuity of life or the future of a business enterprise is to be prolonged or extended indefinitely, i.e., continuance of the activity and not dissolution/liquidation is the normal business process. In other words, a business is viewed as a mechanism for continuous additions of value to the resources or utility used by such unit. The success or failure of the business is measured by the difference between the value of its output (sale/or services) and the cost of such output.
It has been stated above that the business entity has a continuity of life. Since there is some degree of continuity of every entity and no one can accurately predict the future of an entity due to the possibility of cessation of its life, it is more convenient to treat the same as a going concern. But this does not mean that the business entity has a perpetual life.
This concept recognises the value of the assets and liabilities of the business enterprises on the basis of their productivity and not on the basis of their current realisable value on the assumption that they are to be disposed of. Since they are held in a ‘going concern’ for earning revenue and not for resale, there is no such utility to show the expected realisable values in the Balance Sheet. Besides, under this concept, prepaid expenses are recognised as assets since the benefits will be utilised in future when the business entity will continue. Going Concern Concept helps other business undertakings to make contracts with specific business units for business dealings in future. It also stresses more emphasis on the earning capacity in judging the overall performance of the business.
In accounting, all transactions are expressed and interpreted in terms of money. The benefit of this expression is that it provides a common denominator or unit of measurement by means of which heterogeneous facts about a business can be expressed in terms of quantities which can either be added or subtracted. Since different transactions occur they are recorded and interpreted in various accounts in monetary terms. So, accounting helps to express heterogeneous economic activities in terms of money.
Actually the basic purpose of using money is to implement an element of uniformity among diversity. Therefore, fixed assets, like Land, Furniture and Fixtures, are expressed in terms of money and not in terms of area (for land) or quantity (Furniture and Fixtures) for recording in accounts properly, like other assets, e.g. Cash in Hand and Cash at Bank (Which are expressed always in monetary terms).
This method suffers from the following limitations:
(a) It does not recognise the changes in the purchasing power of monetary unit.
(b) It fails to keep any record of such matters which cannot be expressed in terms of money—e.g. Human genius, which may be capable of being highly productive, is not considered in accounting as there is no acceptable value in exchange.
That is, in other words, a fact or an event which cannot be expressed in terms of money cannot be recorded in the books of accounts. Yet, for accounting purposes, it is the best means for measuring varied transactions, e.g. goods, service, natural resources etc.
Accounting is a historical record (on a monetary basis) of the transaction of a business entity. From the historical record of cost, one can ascertain the progress (or otherwise) of the accounting unit with the help of financial statements. According to this concept, an asset is recorded at its cost in the books of accounts, i.e., the price which is paid at the time of acquiring it. When an asset is acquired or purchased, its cost price is the only source by which the basis for all subsequent accounting in relation to the same can be made.
The asset, when it is acquired, is originally recorded at its cost price and gradually reduced by way of depreciation. Amount of depreciation is to be calculated on the basis of its cost prices and the effective life of the asset. The market value of the asset is not to be taken into consideration for the purpose of valuation or depreciation of such asset. This method is closely related to the ‘Going Concern Concept’ method.
This concept, however, has an advantage. Since the valuation of asset does not depend on the market value which again depends on the subjective views of accountants, accounts are maintained properly, i.e., without any personal bias of the accountants. But this concept also suffers from one limitation.
That is, as the cost concept ignores the effect of excessive inflation in the present economy it becomes irrelevant for the purpose of valuation of assets. In order to overcome this shortcoming, inflation accounting and current values of the assets are advocated. Though there are a number of practical difficulties, Cost Concept Method still serves as a fair and adequate basis for the valuation of assets.
A business is assumed to continue indefinitely in order to ascertain the state of affairs of the business at different intervals. We are to choose the intervals for ascertaining the financial position and the operational results at each such interval which, in other words, is known as accounting period. Usually, a period of 365 days or 52 weeks is considered as the accounting period. Sometimes half-yearly or quarterly period is also taken into consideration.
Besides, the interested parties (viz. Shareholders, Creditors, Investors etc.) need periodical reports about accounting of business activities at specific intervals of time for understanding the business performances and for making necessary decisions which will be formulated in near future, However, this concept is particularly applicable to: (i) the valuation of assets and liabilities, (ii) costs between expired and unexpired, (iii) analytical description of financial transactions, (iv) the estimation of profits, (v) the presentation of the true and (vi) fair view of the financial position etc.
Besides, this method helps to measure the income generated during the specific accounting period which also helps to distribute the same periodically. The Accounting Period Concept recognises division and appropriation of accounting records into specific periods. It recognises the measurements of the operating results of each such period. This method also reveals a clear demarcation of accrued or deferred items of incomes and expenses.
The performance of a period is measured by matching cost with revenue. Therefore, total costs and expenses pertaining to the generation of such revenue together with the expenses and cost incurred for the specific accounting period are matched against the revenue for the said period. As such, Accrual System or Mercentaile System of accounting is of fundamental importance in accounting.
The segregation of expenditure between capital and revenue arises from this concept. That is, whether a particular item of expenditure will appear in the income/revenue statement (i.e. P & L A/c) or will appear in the Balance Sheet is to be determined by the accountant on the basis of this concept. Because, a capital expenditure may be treated as revenue one if the period is taken for a decade instead of a year. That is why Accounting Period Concept plays a very significant role in accounting.
This is, no doubt, the basic concept in accounting. Under this concept, every transaction has got a two-fold aspect—(i) yielding to or receiving of benefit, and (ii) giving of that benefit. For instance, when a firm acquires an asset (receiving of the benefit) it must pay cash (giving of the benefit). Therefore, two accounts are to be passed in the books of accounts, one—for receiving the benefit and the other—for giving the benefit. Thus, there will be a double entry for every transaction—Debit for receiving the benefit and Credit for giving the benefit. So, for each and every debit there must be a corresponding credit, and vice versa. This is the principle of Double Entry System of Accounting which, in other words, known as the ‘Dual Aspect Concept’.
The Accounting Equation, i.e. Assets = Equities (or, liabilities + capital) is based on this concept.
Needless to mention that at each and every stage of operation, the assets of any unit must always be equal to its equities (i.e. both internal and external) in terms of money. In short, Assets = Equities. It may be expressed in the following manner:
This concept is also familiar with the names of : Accruals Deferrals, Accounting Adjustments, Amortization, Depreciation, Going Concern, etc.
(i) A = L + P, where A = Assets;
L = External Equities; and
P = Internal Equities/Capital.
or, (ii) P – A-L
or, (iii) L = A-P
This concept recognises that the determination of profit or loss on a particular accounting period is a problem of matching the expired cost allocated to an activity period. In other words, the expenses which are actually incurred during a specific activity period, in order to earn the revenue for the said period, must be matched against the revenue which are realised for that period.
For this purpose, expenses which are specially incurred for earning the revenue of the related period are to be considered. In short, all expenses incurred during the activity period must not be taken. Only relevant cost should be deducted from the revenue of a period for periodic income statement, i.e., the expenses that are related to the accounting period shall be considered for the purpose of matching.
This process of relating costs to revenue is called matching process. It should be remembered that cost of fixed asset is not taken but only the depreciation on such fixed asset related to the accounting period is taken (For the purpose of matching, prepaid expenses are excluded from the total costs but outstanding expenses are added to the total cost for ascertaining the cost related to the period.) Like costs, all revenues earned during the period are not taken, but revenue which are related to the accounting period are considered.
Application of matching concept creates some problems which are:
(a) Some special items of expenses, e.g. preliminary expenses, expenses in connection with the issue of shares and debentures, advertisement expenses etc., cannot be easily identified and matched against revenues of a particular period.
(b) Another problem is that how much of the capital expenditure should be written-off by way of depreciation for a particular period for matching against revenue creates the problems of finding out the expected life of the asset. As such, accurate matching is not possible.
(c) In case of long term contracts, usually, amount is not received in proportion to the work done. As a result, expenditures which are carried forward and not related to the income received may create some problems.
According to this concept, revenue is considered as earned on the date when it is realised. In other words, revenue realised (either by sale of goods or by rendering services) during an accounting period should only be taken in the income statement (Profit and Loss Account). Unearned/Unrealised revenue should not be taken into account. The revenue is treated as earned on some specific matters or transactions.
For example, when goods are sold to customers, they are legally liable to pay, i.e., as soon as the ownership of goods passes from the seller to the buyer. In short, when an order is simply received from a customer, it does not mean that the revenue is earned or realised.
On the other hand, when an advanced payment is made by a customer, the same cannot be treated as revenue realised or earned. In case of hire-purchase transactions, however, the title or ownership of the goods is not transferred from the seller to the buyer till the last instalment is paid, As such, the down payments and the instalment received or due should be treated as actual sale, i.e., revenue earned.
The Historical Cost Concept needs support of two other concepts for practical purposes, viz. (i) the Money Measurement Concept (already discussed above), (ii) the Balance Sheet Equation Concept. Accounting process, however, conforms to an algebraic equation which, in other words, is involved in two laws of nature, i.e., the law of constancy of matter and the law that every effect originates from a cause.
In relation to the former, it may be deducted that all that has been received by us must be equal to (=) all that has been given to us (In accounts, receipts are classified as debits and giving or sacrifices are classified as credits.) Here, the equation comes :
Debit = Credit
(That is, in other words, every debit must have a corresponding equal credit or vice versa.) All receipts (referred to above) may again be classified into : (i) benefits/services received and totally consumed (which are known as expenses), (ii) benefits or services received but not used properly or misused (which are known as losses) and (iii) benefits or services received but kept to be used in future (which are known as assets). Similarly, in the opposite case, all that have been given by others may also be classified into : (i) What has been given to us but-are not to be repaid (which are known as incomes or gains), and (ii) What has been given by the others but has to be repaid at a later date (which are known as liabilities).
Therefore, the above equation may again be rewritten as under:
Expenses + Loss + Assets = Income + Gains + Liabilities
However, if expenses and losses are set off against incomes and gains the same equation will be reproduced in the following form:
Assets = Income + Gains + Liabilities – Expenses – Losses Or, Assets = Net Profit (-) Net Loss + Liabilities
Liabilities become due either to outsider or to the owner, viz. the proprietors, in that case:
Assets = Net Profits or (-) Net Loss + External liabilities + Dues to Proprietors
We know that proprietor’s due increases with the amount of net profit whereas it decreases with the amount of net loss. The same is known as equity in the business.
So, the above-given equation comes down to:
Assets = Equity + External Liabilities Again, from the proprietor’s point of view, the equation can also be rewritten as under:
Proprietor’s Fund or Equity – Assets – Liabilities
From the above, it may be said that the entire accounting process depends on the above accounting equation.
It expresses that accounting data are subject to verification by independent experts, i.e., there must be documentary evidences of transactions which are capable of verification. Otherwise, the same will neither be verifiable nor be realisable or dependable. In other words, accounting data must be free from any bias. Because verifiability and objectivity imply reliability, trustworthiness, dependability — which are very useful for conveying the accounting data and information furnished in periodical accounting reports and statements.
There should always be some documentary evidences in establishing the truth reflected in the said reports or statements. Entries which are recorded in accounting from the transactions and data which are reported in financial statements must be based on objectively— determined evidence. The confidence of users of the financial statement cannot be maintained until there is a close adherence to this principle. Invoices and vouchers for purchases, sales and expenses, physical checking of stock in hand etc. are examples of objective evidence which are capable of verification.
Therefore, it must be said that every entry must be supported by some objective evidence, as far as possible and, as such, it will minimise the possibility of errors and frauds. But, evidence does not always play the most significant role since there are different occasions where significant role is being played by other factors, e.g. personal opinions and judgement, provision for bad debts, valuation of inventories, etc.