What Does Accounting Concepts and Principles Mean?
Accounting principles and concepts are the backbone of effective financial management and transparent financial reporting. These essential guidelines help businesses maintain accuracy in recording and analyzing financial data, ensuring consistency and reliability across the board. Key concepts like the business entity concept, revenue recognition principle, and accrual concept are integral in shaping the way financial information is handled.
In this article, we will break down the meaning of accounting concepts, explain popular accounting principles, and touch on commonly used accounting conventions. Whether you're a beginner exploring accounting for students or a professional looking to refresh your knowledge, this guide offers valuable insights into the core principles and concepts that define the accounting world.
What are the Objectives of the Accounting Concept?
The primary aim of accounting is to maintain uniformity and regularity in the preparation of accounting statements.
Accounting concepts act as an underlying principle that helps accountants in the preparation and maintenance of business records.
It aims to understand the business rules and regulations that are required to be followed by all types of business entities, and hence simplifying the detailed and comparable financial information.
Different Accounting Concepts with Examples
Following are the different accounting concepts that are widely used all around the world and hence are termed as universally accepted accounting rules. The different accounting concepts are:
Business Entity Concept
This concept assumes that the organization and business owners are two independent entities. Hence, the business translation and personal transaction of its owner are different. For example, when the business owner invests his money in the business, it is recorded as a liability of the business to the owner. Similarly, when the owner takes away from the business cash/goods for his/her personal use, it is not treated as a business expense. Thus, the accounting transactions are recorded in the books of accounts from the organization's point of view and not the person owning the business.
Example:
Suppose Mr. Birla started a business. He invested Rs 1, 00, 000. He purchased goods for Rs 50,000, furniture for Rs. 40,000, and plant and machinery for Rs. 10,000 and Rs 2000 remained in hand. These are the assets of the business and not of the business owner. According to the business entity concept, Rs.1,00,000 will be assumed by a business as capital i.e. a liability of the business towards the owner of the business.
Now suppose, he takes away Rs. 5000 cash or goods for the same worth for his domestic purposes. This withdrawal of cash/goods by the owner from the business is his private expense and not the business expense. It is termed as Drawings.
Therefore, the business entity concept states that the business and the business owner are two separate/distinct persons. Accordingly, any expenses incurred by the owner for himself or his family from business will be considered as expenses and it will be represented as drawings.
Accrual Concept
The term accrual means something is due, especially an amount of money that is yet to be paid or received at the end of the accounting period. It implies that revenue is realized at the time of sale through cash or not whereas expenses are recognized when they become payable whether cash is paid or not. Therefore, both the transactions are recorded in the accounting period in which they relate.
In the accounting system, the accrual concept tells that the business revenue is realized at the time goods and services are sold irrespective of the fact when cash is received for the same. For example, On March 5, 2021, the firm sold goods for Rs 55000, and the payment was not received until April 5, 2021, the amount was due and payable to the firm on the date goods and services were sold i.e. March 5, 2021. It must be included in the revenue for the year ending March 31, 2021.
Similarly, expenses are recognized at the time services are provided, irrespective of the fact that cash paid for these services are made. For example, if the firm received goods costing Rs.20000 on March 9, 2021, but the payment is made on April 7, 2021, the accrual concept requires that expenses must be recorded for the year ending March 31, 2021, although no payment has been made until this date though the service has been received and the person to whom the payment should have been made is represented as a creditor of business firm.
In brief, the accrual concept states that revenue is recognized when realized and expenses are recognized when they become due and payable irrespective of the cash receipt or cash payment.
Accounting Cost Concept
The accounting cost concept states all the business assets should be written down in the book of accounts at the price assets are purchased, including the cost of acquisition, and installation. The assets are not recorded at their market price. It implies that the fixed assets like plant and machinery, building, furniture, etc are recorded at their purchase price. For example, a machine was purchased by ABC Limited for Rs.10,00,000, for manufacturing bottles. An amount of Rs.2,000 was spent on transporting the machine to the factory site. Also, Rs.2000 was additionally spent on its installation. Hence, the total amount at which the machine will be recorded in the books of accounts would be the total of all these items i.e. Rs.10, 040, 00. This cost is also termed as historical cost.
Dual Aspect
The dual aspect is the basic principle of accounting. It provides the basis for recording business transactions in the books of accounts. This concept assumes that every transaction recorded in the books of accountants is based on dual concepts. This implies that the transaction that is recorded affects two accounts on their respective opposite sides. Hence, the transaction should be recorded at dual places. It implies that both aspects of the transaction should be recorded in the books of account. For example, goods purchased in exchange for cash have two aspects such as paying cash and receiving goods. Therefore, both the aspects should be registered in the books of accounts. The duality of the transaction is commonly expressed in the terms of the following equation given below:
Assets = Liabilities + Capital
The dual concept implies that every transaction has a similar effect on assets and liabilities in such a way that the value of total assets is always equal to the value of total liabilities.
Going Concepts
The Going concept in accounting states that a business activities will be carried by any firm for an unlimited duration This simply means that every business has continuity of life. Hence, it will not be dissolved shortly. This is an important assumption of accounting as it provides a base for representing the asset value in the balance sheet.
For example, the plant and machinery was purchased by a company of Rs. 10 lakhs and its life span is 10 years. According to the Going concept, every year some amount of assets purchased by the business will be represented as an expense and the balance amount will be shown as an asset in the books of accounts. Thus, if an amount is incurred on an item that will be used in business for several years ahead, it will not be proper to charge the amount from the revenues of that particular year in which the item was purchased Only a part of the purchase value is shown as an expense in the year of purchase and the remaining balance is shown as an asset in the balance sheet.
Money Measurement Concept
The money measurement concept assumes that the business transactions are made in terms of money i.e. in the currency of a country. In India, such transactions are made in terms of the rupee. Hence, as per the money measurement concept, transactions that can be expressed in terms of money should be recorded in books of accounts. For example, the sale of goods worth Rs. 10000, purchase of raw material Rs. 5000, rent paid Rs.2000 are expressed in terms of money, hence these transactions can be recorded in the books of accounts.
Accounting Period Concepts
Accounting period concepts state that all the transactions recorded in the books of account should be based on the assumption that profit on these transactions is to be ascertained for a specific period. Hence this concept says that the balance sheet and profit and loss account of a business should be prepared at regular intervals. This is important for different purposes like calculation of profit and loss, tax calculation, ascertaining financial position, etc. Also, this concept assumes that business indefinite life is divided into two parts. These parts are termed accounting periods. It can be one month, three months, six months, etc. Usually, one year is considered as one accounting period which may be a calendar year or financial year.
The year that begins on January 1 and ends on January 31 is termed as calendar year whereas the year that begins on April 1 and ends on March 31 is termed as financial year.
Realization Concept
The term realization concept states that revenue earned from any business transaction should be included in the accounting records only when it is realized. The term realization implies the creation of a legal right to receive money. Hence, it should be noted that selling goods is considered as realization whereas receiving order is not considered as realization.
In other words, the revenue concept states that revenue is realized when cash is received or the right to receive cash on the sale of goods or services or both have been created.
Matching Concepts
The Matching concept states that revenue and expenses incurred to earn the revenue must belong to the same accounting period. Hence, once revenue is realized, the next step is to assign the relevant accounting period. For example, if you pay a commission to a salesperson for the sale that you record in March. The commission should also be recorded in the same month.
The matching concept implies that all the revenue earned during an accounting year whether received or not during that year or all the expenses incurred whether paid or not during that year should be considered while determining the profit and loss of the business for that year. This enables the investors or shareholders to know the exact profit and loss of the business.
What are Accounting Conventions?
Accounting conventions are certain restrictions for the business transactions that are complicated and are unclear. Although accounting conventions are not generally or legally binding, these generally accepted principles maintain consistency in financial statements. While standardized financial reporting processes, the accounting conventions consider comparison, full disclosure of transaction, relevance, and application in financial statements.
Four important types of accounting conventions are:
Conservatism: It tells the accountants to err on the side of caution when providing the estimates for the assets and liabilities, which means that when there are two values of a transaction available, then the always lower one should be referred to.
Consistency: A company is forced to apply the similar accounting principles across the different accounting cycles. Once this chooses a method it is urged to stick with it in the future also, unless it finds a good reason to perform it in another way. In the absence of these accounting conventions, the ability of investors to compare and assess how the company performs becomes more challenging.
Full Disclosure: Information that is considered potentially significant and relevant is to be completely disclosed, regardless of whether it is detrimental to the company.
Materiality: Similar to full disclosure, this convention also bound organizations to put down their cards on the table, meaning they need to totally disclose all the material facts about the company. The aim behind this materiality convention is that any information that could influence the person’s decision by considering the financial statement must be included.
14 Principles of Accounting
The 14 Principles of Accounting are the key guidelines that ensure accurate and consistent financial reporting. They are used to establish the accounting system and ensure that transactions are recorded and reported in a standard way. These principles also provide a clear framework for accountants to follow.
Here’s a list of the 14 Principles of Accounting:
1. Regularity Principle: This principle states that accountants must adhere to established rules and regulations when recording financial transactions. This ensures consistency in accounting practices across different periods.
Example: Following GAAP (Generally Accepted Accounting Principles) for preparing financial statements.
2. Consistency Principle: Once an accounting method is chosen, it should be used consistently in future accounting periods unless a valid reason for changing it exists. This ensures comparability across financial statements.
Example: Using the same method of depreciation every year unless a change is warranted.
3. Sincerity Principle: Accountants must provide a true and accurate depiction of a company’s financial situation, showing honesty in the reporting of financial transactions.
Example: Avoiding falsification or misrepresentation of financial data.
4. Permanence of Methods Principle: This principle suggests that companies should use consistent accounting methods over time, as changes could confuse stakeholders. It promotes stability and comparability in financial reports.
Example: Continuing to use a single method of calculating depreciation for all fixed assets.
5. Non-Compensation Principle: All financial transactions should be reported without compensating any losses with gains or vice versa. This principle ensures transparency in reporting.
Example: Revenue and expenses should be reported separately without netting off.
6. Prudence Principle: The prudence principle recommends that accountants should not overstate income or assets or understate liabilities. When in doubt, conservative estimates should be used to avoid misleading financial statements.
Example: Recording an allowance for doubtful debts to account for potential non-receivables.
7. Continuity Principle
This principle assumes that a company will continue its operations indefinitely unless there is evidence suggesting otherwise. This assumption allows the business to record its assets at cost, rather than liquidation value.
Example: Recording assets at historical cost under the assumption that the company will continue operations.
8. Periodicity Principle
This principle states that financial reports should be prepared for specific periods, such as monthly, quarterly, or annually, for a consistent basis of comparison.
Example: Preparing income statements on a monthly basis to track performance.
9. Full Disclosure Principle: All material and relevant information about a company’s financial performance and position must be disclosed in financial statements, including in the footnotes, to provide full transparency to users.
Example: Disclosing pending lawsuits or regulatory investigations in the footnotes to the financial statements.
10. Materiality Principle: This principle allows companies to disregard minor details that do not significantly affect the financial statements, thereby simplifying the accounting process.
Example: A company may not record minor office supplies as assets but instead expense them immediately.
11. Matching Principle: This principle requires that expenses should be recorded in the same period as the revenues they helped generate, ensuring that the net income or profit is accurately reflected.
Example: If a company incurs expenses for advertising in January to promote a product, those expenses should be matched with the revenue generated from sales in January.
12. Revenue Recognition Principle: Revenue should be recognized when it is earned, regardless of when payment is received. This principle ensures that income is recorded when a transaction occurs.
Example: A company recognizes revenue when a service is rendered, even if the payment is received later.
13. Economic Entity Principle: The economic entity principle states that a business is a separate entity from its owners, and the business transactions should be recorded separately from personal transactions.
Example: If an owner withdraws money from the business for personal use, it should not be recorded as a business expense.
14. Cost Principle: This principle asserts that assets should be recorded at their original cost, not their current market value. This ensures reliability and consistency in financial reporting.
Example: A company purchases a piece of land for ₹10,00,000. It should be recorded at that cost, even if the market value of the land increases or decreases over time.
Conclusion:
Accounting concepts, principles, and conventions such as the Revenue Recognition Principle and the Matching Principle play a vital role in ensuring accurate financial reporting. These foundational elements provide businesses with a framework to record and report financial transactions consistently and transparently. By adhering to these principles, companies not only maintain compliance with accounting standards but also provide stakeholders with reliable financial information for decision-making. Understanding and applying these concepts is crucial for anyone involved in financial management or accounting, as they form the backbone of accurate and trustworthy financial reporting.
FAQs on Accounting Principles and Concepts
1. What is an Accounting System?
An accounting system is a set of accounting processes, integrated procedures, and controls. The primary motive of the accounting system is to keep up the records of business transactions, compile those transactions into an aggregated form, and draw up a report that can be used by decision authorities to audit, evaluate, and enhance the business operations. There are two types of accounting systems namely single entry system and a double-entry system.
2. What are Expenses?
An expense is the cost of operations that a company incurs to generate its revenue. A popular saying goes, “it costs money to make money.” Expenses include payments to the suppliers, employee wages, factory leases, and equipment or asset depreciation. Examples of Expenses are - Cost of goods sold, Sales commissions expense, Delivery expense, rent expense, Advertising expense, etc.
3. What are Accounting Standards?
Accounting standard refers to the set of rules, guidelines, and principles framed by the regulatory body or the government that act as a framework for accounting policies and practices. In the United States, the Generally Accepted Accounting Principle, also known as GAAP, is an accounting standard that must be followed while presenting and preparing financial statements. Generally,accounting standards are established to ensure transparency of accounting professionals and consistency in accounting principles followed by organizations. All countries have their own accounting standards framed by the regulatory body or the government. However, these standards may vary from one country to another.
4. What is the Revenue Recognition Principle?
The Revenue Recognition Principle dictates that revenue should be recognized in the accounting period when it is earned, regardless of when the payment is received. This principle ensures that businesses report their earnings in the correct period, giving a clearer picture of financial performance. For instance, if a company sells a product in December but receives payment in January, the revenue should be recognized in December, when the sale occurred.
5. What is the Matching Principle in Accounting?
The Matching Principle requires that expenses be matched with the revenues they help generate in the same accounting period. This ensures that the income statement reflects the true profitability of a business. For example, if a company incurs advertising costs to promote a product, those costs should be recognized in the same period as the sales generated by the ads.
6. What is Consistency Principle in Accounting?
The Consistency Principle states that businesses should use the same accounting methods and principles from one period to the next unless there is a valid reason to change. This ensures comparability of financial statements over time, allowing stakeholders to analyze trends and performance. For example, if a company uses straight-line depreciation in one year, it should continue using the same method in subsequent years unless there is a valid reason to switch.
