Tag: Entity concept

Concepts, Principles, And Conventions An Overview

In this tutorial, we will learn about concepts, principles, and conventions an overview of the world’s accountancy bodies may change any gathering to improve the quality of accounting information.

They are the theoretical base for accounting. The following areas widely accepted accounting concepts:

Entity Concept:

It states that a business enterprise is a separate identity apart from its owner. Accountants should treat books of accounts of the business distinct from the personal papers of reports as the owner. Therefore, the business transactions are recorded in the writings of business, not in the owner’s books.

Because of the concept of the amount invested by the proprietor in the company, i.e., the capital is treated as a liability, and the business has to give an interest to the owner. The owner or proprietor invested the money, which is also the risk capital he claims about the business’s profit.

Money Measurement Concept:

It states that only those transactions that package under monetary terms are to be recorded in the books of accounts. The financial value, this concept requires that those transactions alone are capable of being measured in terms of money. Sales and events which cannot be expressed in terms of payment are to be left out.

For example, the enterprise’s employees are undoubtedly the assets of the firm, but they cannot be shown in the balance sheet as they cannot be expressed in terms of money. The measuring unit of money is taken as the currency of the ruling country in which accounts are prepared, i.e., the country’s ruling currency provides a common denomination for the material objects. Now the question arises if the transactions happen across the country’s international borders, then the sales will be recorded in the ruling currency of the foreign country or the country?

The concept ignores that money is an inelastic yardstick for measurement based on the implicit assumption that the purchasing power of the money is not sufficient importance as to require adjustment.

 Periodicity concept: 

This is also called the idea of a definite accounting period. But another idea going concern concept an indefinite life of the entity is assumed. For business, it causes inconvenience in measuring performance achieved by the object in the ordinary course of business. For example, if a textile mill lasts for 100 years, it is not desirable to measure its performances as well as financial position only at the end of its life.

Therefore a small but workable fraction of time is chosen out of the infinite life. Generally, that workable fraction of time is one year. However, some organizations also take nine months or 15 months for performance appraisal of financial position. In India, we follow from 1st April to 31st March of the immediately following year.

The concept helps to differentiate between capital and revenue expenditure, differentiate between long-term liabilities and short-term liabilities. Thus, the periodicity concept facilitates in:

You are comparing financial statements of different periods.

We uniform and consistent accounting treatment for ascertaining the profit and financial position of the firm.

They are matching periodic revenues with the expenses for getting reliable results for business operations.

 Accrual Concept: 

The accrual concept, the effects of transactions, and other events recognized when they occur and not as cash or cash equivalent are received or paid. They are recorded in the accounting records and reported in financial statements of the periods to which they relate.

Financial statements are prepared on the accrual basis to inform users not only about the past events that took place in the fiscal year but also the future obligations cash soon or cash is received in the future.

To understand the concept better, let us give you some examples.

XYZ CO. sold $15000 worth goods to ABC Co. on 1st April 2016. But ABC Co. made the payment a week later.

But in the books, XYZ Co. sales are to be recorded on 1st April, not when they received payment. It happened due to the Accrual Concept.

Accrual means recognizing revenue and costs as they earned or incurred and not as money is received or paid. The accrual concept relates to the measurement of income identifying assets and liabilities.

According to the Accrual concept: Revenue- Expenses= Profit or

Cash received in the ordinary course of business- Cash paid in the ordinary course of business = Profit

Matching Concept: 

The concept talks about that all the revenue incurred in the specific period must be matched with the expenses of that time only.

It concentrates on actual inflow and outflow, which leads to adjustments of certain items like prepaid and outstanding salaries, rent, insurance, and unearned and accrued incomes.

Not every expense needs to identify its revenue or income. Some costs are directly related to the tax, and some are time-bound. E.g., selling expenses are directly related to sales, but rent and salaries were recorded on an accrual basis.

Going Concern Concept: 

The financial statements are prepared with the assumption that the business will last foreseeable future. Hence it is assumed that the company doesn’t have the intention to liquidate. Traditionally, accountants follow historical costs in the majority of cases.

The essential differentiation between goods and assets is that assets are purchased to increase the business’s productivity and remain in the market for the period, not less than five years. In contrast, products are sent or manufactured for selling purposes.

 Cost Concept: 

This concept says that the valuation of assets is to be done based on historical cost or acquisition cost, i.e., the price at which the asset is purchased. For example, XYZ Co. purchased machinery for 1, 00,000 (INR) on 1st April 2015, but on 31st March 2016, the machinery’s market value was 2, 00,000. But due to the Cost Concept, the balance sheet will reflect the mechanism at 1, 00,000 as it is the historical cost or the acquisition cost.

However, the cost concept creates a lot of distortion, too, as outlined below:

When prices go up in an inflationary situation, prices of all commodities go up on average, and acquisition cost loses relevance.

For example, land purchased on 1.1.1996 for 2000(INR) may cost 1, 00,000(INR) on 1.1.2016.

Actual cost based accountants may lose comparability. Suppose Mr. X invested 10,000 (INR) in Plant A, which produced 5,000(INR) cash inflow, and Mr. Y invested 5,00,000(INR) and got a cash inflow of 50,000(INR) during the year. Who is more efficient? Since the assets were recorded at historical cost, the results are comparable. It is a collar to point

The most valuable assets are the human resources, but they do not have acquisition cost. The cost concept fails to recognize such assets, although it is an essential asset of any organization.

Realization Concept: 

Any change in an asset will be recorded when the business realizes it. When the asset is recorded at the historical cost of 5, 00,000 (INR), and even its current prices are 15, 00,000(INR), such change is not counted unless there is undoubted that such change will materialize.

However, accountants follow a more conservative path. They add all the probable losses but do not count the future losses.

They can decrease the value of an asset if they anticipate a future decrease, but if any future increase, they ignore it. Economists consider such a concept creates value distortion. Nowadays, the revaluation of assets has become widely popular. Accountants adjust such a change in value through the creation of revaluation reserve or capital reserve.

Dual-Aspect Concept: 

The concept is the core of the double-entry book-keeping. Every transaction or event has two aspects:

  •  It increases one asset decreases another asset.
  • It raises an asset simultaneously increases liability.
  • It reduces one asset, increases another asset.
  • It falls one asset, declines a liability.

Alternatively:

  1. It increases one liability, decreases other burdens.
  2. It raises a debt, increases an asset.
  3. It reduces liability, increases additional difficulties.
  4. It declines liability, decreases an asset.

For example, a new machine is purchased paying 5,000(INR) than on the one hand; it increases the industry; on the other hand, it reduces the cash of the company.

This concept can be explained algebraically,

Equity(E) + Liabilities(L)= Assets(A)

Or

Equity(E)= Assets(A)-Liabilities(L)

Or

Equity(E)+Long Term Liabilities+ Current Liabilities = Fixed Assets +Current Assets

Or

Equity(E) + Long term Liabilities = Fixed Assets + (Current Assets – Current liabilities)

Or

Equity(E)=Fixed Assets+ Working Capital- Long term Liabilities

Whatever is received as funds are either expended- Debited to Profit & Loss Account

Or Lost- Losses to have been transferred to a capital account.

Or saved – Shown on the assets side of the Balance sheet.

Therefore, Capital + Income/Profit + Liabilities = Expenses +Net loss + Assets

Or

Capital + Income – Expenses + Net Profits= Assets-Liabilities

Since the net profit/ loss is transferred to equity, the net effect is

Equity + Liabilities = Assets.

Conservatism: 

It states that the accountant should not anticipate income and should provide for all possible losses. If an accountant should choose the method that leads to a lesser amount when there are many alternative values of an asset, due to this concept, we have the golden value cost or net realizable value, whichever is lower.

For this concept, the financial statement has the following qualitative characteristics.

  1. Prudence, i.e., judgment about the future possible losses to have been guarded as well as uncertain gains.
  2. Neutrality, i.e., financial statements, are to be made with an unbiased outlook.
  3. Faithful representation of alternative values.

 Consistency:

In financial statements, comparable accounting policies are followed consistently from one fiscal year to another; change in accounting policy is made only in certain exceptional circumstances.

It is applied when alternative methods of accounting are equally acceptable. For example, a company follows a straight-line method when specific other ways of depreciation are available and widely accessible. Changing the plan is a long process, and the accountant has to make many adjustments.

There is no hard and fast rule that an enterprise cannot change its accounting policy but under certain circumstances, only to bring the books of accounts following the issued accounting standards to comply with the provision law when under changed conditions, that the new method will reflect a more accurate and fair picture in the financial statement.

Materiality: 

It permits other concepts to be ignored if the effect is not considered material. According to it, all items which have a significant impact on the financial statement should be disclosed. Any insignificant item which will only increase the accountant’s work but will not be relevant to the users’ need should not be published in the financial statements.

For example, depreciation on small items says calculators or stationary is taken as 100% in the year of purchase though used by the company for more than a year. They are very small or nominal to be written in the balance sheet.