financial Accounting: Accounting concepts & principles
In this topic we will cover Accounting concepts and principles which are the basis of accounting statements and useful for commerce and management students.
Accounting concepts and principles
Accounting principles, concepts and conventions commonly known as Generally Accepted Accounting Principles or GAAP`s are the basic rules that define the parameters and constraints within which accounting operates. These principles are the theory base of accounting, on the basis of which financial statements are prepared. They are the guidelines for preparing the financial statements.
“Principles of accounting are the general law or rule adopted as a guide to action , a settled ground or basis of conduct or practice.”American Institute of Certified Public Accountants
Accounting principles are the basic or fundamental propositions generally accepted by accountants as aset of accounting principles (rules adopted by accountants universally while recording accounting transactions)based on which transactions are recorded and financial statements are recorded and prepared.
These principles are classified into two categories:
- Accounting concepts
Accounting concepts are the basic assumptions within which accounting operates. They are generally accepted accounting rules based on which transactions are recorded and financial statements are prepared.
- Accounting conventions
Accounting conventions are the outcome of accounting practices or principles being followed by the enterprises over a period of time. They may undergo a change with time to bring about improvement in quality of accounting information.
Fundamental accounting assumptions or concepts
- Going concern concept: According to This, it is assumed that business shall continue for a foreseeable period and there is no intention to close the business or scale down its operations significantly. It is because of This concept that a distinction is made between capital expenditures I.e. expenditure that will give benefit for along period and revenue expenditure i.e one whose benefit will be consumed within the same accounting period. On the basis of This concept fixed asset is to be recorded at their original cost and they are depriciated in a systematic manner over their expected useful life.
- Consistency assumption: According to this concept, accounting practices once selected and adopted , should be applied consistently year after year. It helps in better understanding of accounting information and makes it comparable with that of previous years. The concept is particularly important when alternative accounting practices are equally acceptable e.g. different methods of depriciation are acceptable . under This method . method once chosen and applied should be applied consistently year after year to make statements comparable.
- Accrual assumption : According to This concept, a transaction is recorded in the books of account at the time when it is entered into and not when the settlement takes place. Thus revenue is recognized when it is realized I.e. when sale is complete or services are rendered. It is immaterial whether cash is received or not. Similarly, expenses are recognized as expenses in the accounting period in which the revenue related to it is recognized, whether paid in cash or not.
- Accounting entity or business entity principle: According to this principle, business is considered to be separate from its owners. Business transactions are recorded in the books of account from the business point of view and not from that of the owners. Owners being regarded as seperate from business are considered as creditors of the business to the extent of their capital. Their account with the business is credited with the capital introduced and profit earned during the year, etc. And debited by the drawings made. This principle applies to every form of enterprise including proprietorship firms.
- Money measurement principle: According to this principle, transactions and events that can be measured in money terms are recorded in the books of account of the enterprise. This principle suffers from major limitations:transactions and events that cannot be measured in money terms are not recorded in the books of account, howsoever important they may be to the enterprise. And the value of money is considered to have static values the transactions are recorded at the value on the transaction date.
- Accounting period principle: This principle states that the life of an enterprise is broken into smaller periods so that its performance is measured at regular intervals. The accounts of an enterprise are maintained following the going concern concept. Users of financial statements , especially the management and banks, require information from the accounts at regular intervals so that decisions can be broken at the appropriate time. Management requires information at regular intervals to assess the performance, funds requirement, banks require accounting information periodically because they have invested money and have to ensure its safety and returns. Similarly government has to assess tax dues from the enterprise. An accounting period is the interval of time at the end of which income statement( profit and loss account or statement of profit and loss) and balance sheet are prepared to know the results and resources of the business.
- Full disclosure principle: This principle states that there should be complete and understandable reporting on the financial statements of all significant information relating to the economic affairs of the entity.apart from legal requirements, good accounting practice requires all material and significant information to be disclosed.
- Materiality principle: Materiality principle refers to relative importance of an item or an event. According to to american accounting association,”an item should be regarded as material if there is a reason to believe that knowledge of it would influence the decision of an informed investor.” and only those items should be disclosed that have significant effect or are relevant to the user.
- Prudence or conservatism principle: Prudence or conservatism principle states that anticipated expenses and losses should be accounted. Thus, as a result liabilities may be overstated. This principle can be described as,”do not anticipatea profit, but provide for all possible losses.”the concept of conservatism needs to be applied with caution and care so that the results reported are not distorted.
- Cost concept or historical cost principle: According to to this concept, an asset is recorded in the books of account at the price paid to acquire it and the cost is the basis for all subsequent accounting of all asset. Asset is recorded at cost at the time of its purchase but is systematically reduced by charging depriciation. Cost concept brings objectivity in the preparation and presentation of financial statements. They are not influenced by the personal bias or judgement.
- Matching concept or matching principle: An important objective of business is to determine profit periodically. It is necessary to match revenues of the period with the expenses of that period to determine correct profit or loss for the accounting period. Profit earned by the business during a period can be correctly measured only when the revenue earned during the period is matched with the expenditure incurred to earn that revenue. Therefore, as per this concept, adjustments are made for all outstanding expenses and prepaid expenses. This concept should be followed while preparing financial statements to have a true and fair view of the profitability and financial position of a business firm.
- Dual aspect or duality principle: As per this principle, every transaction entered into by an enterprise has two aspects, a debit and a credit of equal amount. For every debit, there is a credit of equal amount in one or more accounts. It is also true vice versa.
- Revenue recognition concept: This concept states that revenue is considered to have been realised when a transaction has been entered into and the obligation to receive the amounts established. It is to be noted that recognising revenue and receipt of an amount are two seperate aspects.
- Verifiable objective concept: This concept states that accounting should be free from personal bias. Measurements that are based on verifiable evidences are regarded as objective. It means all accounting transactions should be evidenced and supported by business documents. These supporting documents are cash memo, invoices, sales bills, etc.