Accounting Concepts - Essay Example

?Accounting Concepts Introduction Accounting concepts and conventions together form a unique structure to the way various accounting practices must be performed. The term ‘concept’ represents accounting postulates, which are the basic assumptions on the edifice of which the accounting framework is based. This paper will evaluate 10 key concepts of accounting and demonstrate by a suitable example for each concept as to how they help accountants prepare universally comparable, understandable, reliable and relevant set of accounts. The ten key concepts of accounting include business entity, money measurement, going concern, dual aspect, periodicity concept, historical cost, matching, realisation, accrual, and objective evidence. Business entity concept Business unit or business entity is an organisation established by an individual or group of individuals so as to accomplish a set of economic goals. Under this concept, business unit is to be treated separately from the businessman. The business entity concept can be illustrated as an accounting equation; Assets = Liabilities+Capital. This equation clearly indicates that the business unit itself owns assets and in turn owes same level of liabilities too. Since this concept separates business from businessman, it is easy for accountants to distinguish personal assets and liabilities of the businessman from those of the business. This concept restricts the amount of economic data in an accounting system to data directly linked to the business activities (Warren et al 2008, p.8). In a global context, this concept helps to evaluate and compare business data, particularly the economic data related directly to sole proprietorship and partnership ventures. Money measurement concept According to the money measurement concept, all types of business transactions are recorded in terms of money in accounting (Pendlebury & Groves 2004, p. 12). In other words, transactions which cannot be recorded in terms of money are not included in the books of accounts (ibid). For instance, suppose a business enterprise owns land (1000 sq. mtrs.), building (10 rooms and conference hall), 250 chairs, 10 tons of raw materials, and other items. If these items are recorded without any common measurement unit, it would be very difficult to evaluate their value. Under the money measurement concept, these items can be recorded as a land worth $100,000, a building (containing 10 rooms and conference hall) worth $500,000, 250 chairs at $50 each, and so on The money measurement concept assumes that money is a stable unit of measurement and therefore the value of money does not change with time. Going concern concept The going concern concept implies that accounting transactions are recorded keeping the view that the business will exist for a long period of time. More precisely, a business enterprise is considered to be a going concern but not a liquidated one. As per the going concern concept, asset valuation is done at historical cost or replacement cost. The going concern concept is a fundamental principle to the preparation of financial statements (Rajasekaran 2011, p.18). In case of short term business projects like building construction, the business comes to an end once the construction of the particular building is completed. In contrast, some business entities that operate in the automobile or consumable goods industry exist for a long period and they will continue their business activities in the foreseeable future. According to this concept, business enterprises treat prepaid expenses as assets in their balance sheets even though they are not saleable practically. Dual aspect concept Dual aspect concept is one of the fundamental accounting concepts and assumes that every transaction has a two-fold aspect – giving certain benefits and receiving certain benefits. The underlying principle of the double entry system is that every debit has an equal and corresponding amount of credit (Johnston & Johnston 2006, p.54). From the accounting equation (Assets = Liabilities+Capital), it is possible to derive that Capital = Assets – Liabilities, which can clarify the dual aspect concept more. The accounting information implies that total assets of a business unit will be equal to its total liabilities at any particular point of time. Here, liabilities relate both to external people and to owners (capital). For instance, John commenced a business with an initial capital of $200,000. The amount introduced by John into the business will lead to an increase in the assets by $200,000. At the same time, the owner’s equity will be also increased by $200,000. Periodicity concept Under the periodicity concept, the life of a business enterprise is divided into different periods in order to evaluate the operating outcomes of each period separately (Erlinda & Rosario 2005, p. 29). This concept would greatly assist managements to measure the revenues and to ascertain the financial position of the organisation for a shorter and specified time period and this strategy in turn is beneficial to take corrective actions at appropriate time (ibid). Generally, such a period is called accounting period or fiscal period and it involves one year normally. The business enterprise prepares an Income Statement and Balance Sheet at the end of the accounting period respectively to identify the profit/loss made during the period and to obtain a clear view of the financial position of the concern. For example, if the company owes $50,000 to banks and individuals at the end of the accounting period, it should be recorded under the head ‘sundry creditors’ in the liability side of the balance sheet. Historical cost concept According to the historical cost concept, while treating an asset purchase in the books of accounts, the actual cost paid to purchase that asset has to be recorded (Marriott, et al 2002, p. 218). In other words, an asset should be recorded at its original cost but not market value and the same cost must be considered in the subsequent accounting periods too (ibid). The actual cost of the asset is reduced in subsequent years by charging the depreciation estimated. For instance, assume that a firm purchased 100 units of a particular item one month back at $10/unit. Today, the price has increased to $11/unit. However, the inventory will be appeared as $1,000 ($10?100) in the balance sheet, but not $1,100 ($11?100). Matching concept According to this concept, once the total revenue is recognised for the particular accounting period, the total costs incurred to earn that revenue need to be charged against the revenue earning during that period so as to ascertain the net income/loss of the business enterprise (Rajasekaran 2011, p.21). In simple words, matching revenues against corresponding costs is the essence of the matching concept. The matching concept necessitates the provisions for different accounting treatments including outstanding expenses, prepaid expenses, accrued income, and income received in advance. To illustrate matching concept, assume that a pharmaceutical company pays $10,000/month to its five medical representatives. Monthly sales of the company are $300,000. According to the matching concept, $50,000 worth monthly salaries have to be charged against $300,000 earned in revenues. Realisation concept Realisation concept simply implies that the seller recognises revenue regardless of whether cash has been received or not once a sale is made. Hence, timing of the revenue recognition can be considered as the essence of the realisation concept. Hanif (2001) treats it as the process of converting rights and non-cash resources into money (p.3.4). It is often not possible to ascertain when the revenue for a particular sale is realised. Hence, credit sales are taken into account so as to determine the profit for the accounting period under consideration. To illustrate, Mr. A purchased goods worth $100 from B & K enterprises for credit on 21st March 2013. Mr. A settled the price in full after 10 days of purchase. According to the realisation concept, B & K enterprises books of accounts will show that the amount was settled at the point of sale. Accrual concept “The accrual concept is an accounting system which recognises revenues and expenses as they are earned or incurred, respectively, without regard to the date of receipt or payment” (Hanif 2001 , p.3.4). In simpler words, revenue is recorded in the books of accounts on its realisation but not its actual receipt. In the same way, expenses have to be recognised when they are incurred but not when the payment is made actually. To illustrate, a business unit paid $5,000 in rent for the building and machinery a year whereas it had owed only $4,500 in rent. That means the company prepaid $500 in rent. At the end of the accounting period, the prepaid rent ($500) is recorded on the asset side of the balance sheet. Objective evidence concept The object evidence concept says that all accounting activities must be objective evidence based. In other words, there should be adequate verifiable documents to support the reliability of every transaction recorded in the books of accounts. This is very essential for auditors to verify the reliability of accounts prepared. It is to be noted that the verifiable evidences must be objective but not subjective. For instance, a business entity has to keep receipts for the building rent paid. Conclusion From the above discussion, it is clear that all the ten accounting concepts explained are greatly beneficial for accountants to prepare universally comparable, understandable, reliable, and relevant set of accounts. These accounting concepts give a standard structure to books of accounts prepared globally. References Erlinda & Rosario. (2005) The Accounting Process. Goodwill Trading Co., Inc. Hanif, M. (2001) Modern Accounting. New Delhi: Tata McGraw-Hill Education. Johnston, D. C & Johnston, D. (2006) Introduction To Oil Company Financial Analysis. PennWell Books. Marriott, P et al. (2002) Introduction to Accounting. SAGE. Pendlebury, M. W & Groves, R. E. V. (2004) Company Accounts: Analysis, Interpretation And Understanding. Cengage Learning EMEA. Rajasekaran, V. (2011) Financial Accounting. New Delhi: Pearson Education India. Warren, C. S. et al. (2008) Accounting. US: Cengage Learning. Read More