CSS Forums - Accounting concepts

Accounting principles are basic concepts that are applied in recording transactions and preparing financial statements. These rules are necessary to ensure that accounting records provide reliable information. All businesses should apply the rules in their financial statements. Followings are the most important rules to be applied when preparing financial statements:

[B][U][COLOR=navy]1. Business entity:[/COLOR][/U][/B]

Every business is regarded as having an existence separate from that of its owner. The business entity concept implies that the affairs of a bisiness are to be treated as being separate from the non-business activities of its owner (s). Thus, only those itmes which are related to the business are to be recorded in the books. Those transactions which take place out side the business and are personally related to the owner (s) are not recorded in the books; investment of new capital and taking off drawings are an exceptional case.

It is important to remember that this is only an accounting concept. Anyone, who has grievance against a business may legally sue the owner (s) of a firm as business is not regarded as a separate entity for that purpose.

[B][U][COLOR=navy]2. Money measurement:[/COLOR][/U][/B]

This concept states that only those transactions which can be expressed in monetary terms should be recorded in the books. For instance, good, fixed assets, liabilities, debtors, creditors, etc.

Some people think that accounting and financial statements tell you everything about a business. Unfortunately, this is not the case. Some of the benefits to the firm may arise from expenditure (such as providing safe and healthy working conditions) which cannot be expressed in monetary terms and ,thus, are not recorded in the books. Therefore, under this concept only those business transactions are recorded which can be evaluated in monetary terms.

[B][U][COLOR=navy]3. Historic cost:[/COLOR][/U][/B]

Under this concept, transactions are recorded in the books at their actual cost to the business. In most cases, these costs might be ascertained from invoices and other documentary evidences. This treatment is said to be objective because it is based on fact and not on opinion.

An alternative to recording assets and expenses at cost is to record them at a valuation. This introduces subjectivity into the accounting records as it is likely that no two people may agree on the value of the assets or services.
There are two disadvantages to this concept. The first one is that it ignores the changing value of money and the second is that, like money measurement, historic cost does not allow things that cannot be expressed in monetary terms to be recorded in accounting.

[B][U][COLOR=navy]4. Realisation:[/COLOR][/U][/B]

Goods are realized when actual sales take place and when they are converted into money.

The realization concept states that unless goods are realised no sales should be recorded in the books. For instance, if a man goes into a shop and says that he will return tomorrow and buy a pair of shoes, there is no sale yet; but if the man returned the next day and buys the shoes, the sales has become a fact. By selling the shoes, the shopkeeper has converted goods into money. The sale has been realised.

It prevents revenue from being credited and overstated in the accounts before it has been earned, which may result in biased informations.

[B][U][COLOR=navy]5. Duality:[/COLOR][/U][/B]

This states that there are two aspects for each transaction – debit and credit – which always equal to each other. It reflects the accounting equation:

Asset = Capital + Liability

*Double entry is the name given to the method of recording transactions under duality concept.

[B][U][COLOR=navy]6. Consistency:[/COLOR][/U][/B]

It is important for any business to use the most reliable accounting methods. However, it does not mean that these accounting methods should be changed every year; as this may lead to misleading profits calculated from the accounting records. There always should be a consistency in the accounting methods in order to avoid misleading profits.

Thus, the consistency concept states that transaction of similar nature should be recorded in the same way in all business accounting year. It ensures that the profits or losses of different periods and Balance Sheet, can be compared meaningfully.

However, it does not mean that the business has to follow same account methods would only be permissible if it could be shown that the new method will give a fairer presentation of the results and of the financial position of the business. Also the effect of the changes should be shown in either profit and loss account or in one of the reports that accompany it.

[B][U][COLOR=navy]7. Materiality:[/COLOR][/U][/B]

Amounts recorded in the books should be material (significant). The decision as to what is material and what is not depends on the business. An amount maybe considered material in the accounts if its inclusion in, or omission from, the Profit and Loss Account or Balance Sheet would affect the way people would read and interpret those financial statements.

Thus, materiality concept permits the business to disregard and generally accepted principle for recording amounts if they are insignificant in the context of the business as a whole.

The concept does require that all items which are sufficiently material to affect evaluations or decisions should be disclosed.

[B][U][COLOR=navy]8. Accruals (matching):[/COLOR][/U][/B]

If the final accounts of a business are to give reliable information, the revenue and the other income must be no more or less than the business has earned in the period covered by the Profit and Loss Account. The expenses in the Profit and Loss Account should fairly represent the expenses incurred in earning that revenue.

Trading and Profit and Loss Accounts should be prepared on accruals, or matching, basis so that expenses are matched to the revenue earned; that is, expenses should be shown in the Profit and Loss Account as they have been incurred rather than as they have been paid.

[B][U][COLOR=navy]9. Prudence:[/COLOR][/U][/B]

The prudence concept is intended to prevent profit from being overstated. If profit is overstated, a trader may believe that his income is more than it really is, and he may withdraw too much money from the business. That would lead to the capital invested in the business being depleted. If it happens too often the business will collapse because there will not be enough money to pay creditors or to renew assets when they are worn out. The principle is sometimes known as the concept of conservatism. It is safer for profit to be understated rather than overstated.

Prudence is about:
(a) Profits not being overstated;
(b) Losses being provided for as soon as they are recognised.

The application of this concept requires that:
(a) Revenue is not anticipated before it has been realised;
(b) All costs of earning revenue brought to account in the period are charged against that revenue.

[B][U][COLOR=navy]10. Going concern:[/COLOR][/U][/B]

A business is a going concern if there is no intention to discontinue it in the foreseeable future. If it is short of working capital and the owner is unable to put more money into it, or to find somebody who will be prepared to lend it money, it may be unable to pay its creditors and forced to close.

Unless stated to the contrary, it is assumed that the accounts of a business are prepared on a going concern , the assets should be valued in the Balance Sheet at the amounts they could be expected to fetch in an enforced sale, which could be much less than their real worth. Balance Sheets should always show a realistic situation, bearing in mind the weakness of the business.

[B][U][COLOR=navy]11. Substance over form:[/COLOR][/U][/B]

These words are used to describe the accounting treatment of something that does not reflect the legal positions.

For example, a machine bought on hire purchase remains the property of the seller until the final instalment has been paid. If the purchaser fails to pay the installents as they become due, the seller may reclaim the machine. That is the legal position, or the ‘form’.

However, the machine is being used in the purchaser’s business in the same way as the other machines that have not been bought on hire purchase. From an accounting point of view and for all practical purposes, the machine is no different from the other machines; that is the ‘substance’ of the matter.

The practical view (the substance) is preferes to the legal view (the form) in the accounting treatment. This is known as ‘substance over form’.

[B][U]Reference:[/U][/B] H Randall's Accounting books.