Let’s imagine a situation where you give your books of accounts to 3 different accountants for preparing Financial Statements and all 3 of them came to you with the Final report which shows different profits with huge variations between them. They have also presented the Financial Statement very different from each other. As a user of the final accounts yourself, you’ll be confused that which one has done the right calculations. To avoid this confusion, a generally accepted set of rules provides unity of understanding and approach in the practice of accounting and in better presentation of the financial statements.
Accounting is a language of the business. Financial statements prepared by the accountants communicate financial information to the users of the accounts in a way that they can make an informed decision. Thatswhy, it’s very important that financial statements prepared by different organizations for different periods should be uniform. Consistency is very important across the organizations and over a period of time otherwise there will be an utter confusion. There will also not be a fair and true comparison between performances of different organizations or the performance of an organization between past and current periods.
To avoid confusion and receive uniformity, accounting process is performed within the framework of GAAP (Generally Accepted Accounting Principles). GAAP describes the rules developed for the preparation of the Financial Statements. These rules are termed as conventions, principles, concepts, etc. These GAAP rules are the backbone of the accounting system.
Accounting Principles are the basic assumptions and norms on which the whole accounting process is based. Apart from this, accountants also follow various Accounting Standards prescribed by the regulatory authority which provides standardization of accounting policies to be followed under specific circumstances.
The terms “convention”, “concepts” or “principles” are slightly different when it comes to their dictionary meanings but they are used interchangeably in the accounting theories.
Accounting Principles are accounting assumptions which have been adopted by various organizations over a period of time and have a broad consensus if not universal applicability. They serve as an explanation of the current practices and as a guide for selecting the correct procedure when alternatives exist.
1. They should be based on real assumptions;
2. They should be simple, understandable and explanatory;
3. They must be followed consistently;
4. They should be able to reflect future predictions;
5. They should be informational for the users.
1) Entity Concept: Entity concept states that a business enterprise is a separate identity apart from its owner. Accountants should treat business distinct from its owner. Business transactions are recorded in the business books of accounts and owner’s transaction are recorded in his personal books of accounts.
This practice of distinguishing the affairs of the business from the personal affairs of the owner is followed in all types of organizations whether a sole-proprietorship or a partnership or a company.
This concept makes the enterprise liable to the owner for the capital investment made by him in the business. Since the owner has to bear the risk on his invested capital, he has a claim on the profit earned by the business as well. The portion of profit apportioned to the owner/shareholders immediately becomes a current liability in the books of the firm.
E.g. Mr. Alex started a business by investing $25,000 with which he purchased Machinery for $5000, stock for $1,600, land & buildings for $8,100 and maintained the balance in hand. After a month, he withdrew $3,000 cash to meet his family expenses. Represent the financial position of the business.
|Liabilities||Amount (in $)||Assets||Amount (in $)|
Land & Buildings
For personal use
2) Money Measurement Concept: This concept states that only those transactions can be recorded in the books of accounts which can be measured in monetary terms. Money is a medium of exchange and has an economic value attached to it, so its easy to calculate and compare the business’s performance in monetary terms.
There are transactions which are significant to the business and they also affect the performance materially, but if they can’t be expressed in monetary terms they are not capable of being recorded in the books of account. This loophole comes with this principle and accountants also agree with this.
E.g. Suppose the CFO of the company resigns and it impacts the profits of the company for that year significantly. Although it can’t be expressed in monetary terms but it is material to the business and also to the users of the accounts to make an informed decision.
As an accountant its your job to make all the material information available to the users of accounts in a fair and transparent way. So, these significant events of the business are presented in the “Notes to accounts” of the company’s Financial Statements.
Also, the books of accounts is always maintained in the currency of the country in which the firm operates. If any transaction occurs across the boundary of that country, then that transaction amount is converted into the currency of the local country and then it is recorded in the books.
3) Periodicity Concept: Periodicity Concept states that even though it is believed as per the ‘going concern’ concept that the firm is assumed to go for an infinite period of time but it is not practical or convenient to measure the performance of the firm at once when the business shuts down. So, small workable period of time is chosen out of the infinite period to measure the performance and analyze the financial position of the firm. Generally this period is of an year, but it can vary firm to firm. It can be 6 months, 9 months or 15 months as well.
The period of an year can be a calendar year (1st January to 31st December) or a financial year (1st April to 31st March) as it is followed in India.
(i) Comparing financial statements of different periods
(ii) Uniform and consistent accounting treatment
(iii) Matching periodic revenues with the expenses for getting correct results of business operations
(iv) To make the term “accrual” meaningful, in an indefinite time period nothing can accrue. There will not be any prepaid or outstanding expenses/revenue.
4) Accrual Concept: Under accrual concept, the effect of transactions and other events are recognized of mercantile basis i.e. when they occur, and not when cash is received or paid for that transaction. They are recoded in the books of accounts and reported in the financial statements of the period to which they relate.
As a result of the accrual system, the users get to know about all the past payments due (outstanding expenses), advance payments made (prepaid expenses), income due to receive (accrued income) and advance income received (advance income).
5) Going Concern Concept: The financial statements are prepared with an assumption that an enterprise is a going concern and will continue in operations for the forseeable future. Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate the business.
If such condition or need arises, it needs to be disclosed in the Financial statement and the books need to be prepared accordingly as the valuation of assets of the entity is dependent on this assumption.
If going concern approach is followed, then increase or decrease in the value of assets in the short-run is ignored. The concept indicates that assets are kept for generating income in future, not for immediate sale. Current changes in assets are not realizable until it has to be sold immediately (in case of liquidation), hence it should not be counted.
6) Matching Concept: According to this concept, all the expenses which matches to the revenue of that period should be taken into consideration. It means that if any revenue is recognized in a period, then the expenses relate to earn that revenue should also be recognized in that period only.
This concept is based on the concept of accrual, i.e. it concentrates on the occurrence of and doesn’t take into concern the actual inflow or outflow of cash for recording the income or expenses.
Having said that, it is to be noted that not every expense identify every income. Some expenses are directly related to the revenue and some are time bound. E.g. selling expenses are directly related to the sales, but expenses like salaries, rent, etc. are recorded on accrual basis for a particular period.
E.g. Mr. Simon started a grocery business. He purchased inventory worth $90,000 and sold groceries for $80,000 (cost $60,000) during the accounting period of 12 months. He paid shop rent for $1,500 per month for 11 months. He paid $50,000 to the suppliers and received $75,000 from the customers.
As per the periodicity concept, the time-frame for which the operations need to be measured is Jan 1st, 2017 to Dec 31st, 2017 and the financial position needs to be ascertained as on 31st December, 2017.
As per the accrual concept, the revenue accruing to this period is $80,000 (the sales made and not the cash received from the customers). Similarly, the expenses accruing to the period would be $60,000 for groceries (not $50,000 paid) and $18,000 for 12 months rent expenses (not $16,500 paid for 11 months).
Hence, the matching concept works on the basis of accrual concept and periodicity concept.
Revenue – Expenses = Profit
Periodic Revenue – Matched Expenses = Periodic Profit
So, the Statement of operations will be as follows:
Revenue: From sale of groceries $80,000
Expenses: For cost of inventory $60,000
For Rent Expenses $18,000 $78,000
Profit for the year $2,000
Debtors $ 5,000
Cash ($75,000 - $50,000-$16,500) $ 8,500
Trade Creditors $40,000
Expenses Payable $ 1,500
Capital (for profit/loss) $ 2,000
7) Cost Concept: This concept states that the value of assets is to be determined on the basis of the historical cost, or acquisition cost. This concept is used by the accountants in the interest of objectivity, i.e. this approach is free from all bias. Other approaches are judgment based, hence can be biased. They are also not so easily measured.
Hence, until the machinery is actually sold, realizable value or market value is not used.
However, this concept had a lot of distortions:
(i)In an inflationary condition when prices of the assets go up, this concept can lose its relevance as it does not show the accurate financial position of the firm. E.g. in case of land and buildings.
(ii)Many assets doesn’t have an acquisition cost, e.g. human resources, this is not recognized by this concept although it is an important assets for the enterprise.
Many controversial issues arose around this concept, hence we will later see that this concept is not followed in every circumstances.
8) Realisation Concept: This concept follows the cost concept closely. It states that any change in the realizable value of the assets will be recorded only when there is a level of certainty that such change will materialize.
However, the accountants follow a more conservative path. They record all the probable losses/ decrease in the value of assets but not all the possible increase/gains.
E.g. A building with a historical cost of $5,000 has a current market value of $25,000. This will be shown under this concept as follows:
Nowadays, the revaluation concept has taken its place where the increase/decrease is treated has a permanent nature.
9) Dual Aspect Concept: This concept is the core of the double entry book-keeping system as we have discussed earlier. It states that -
‘Increase in an asset either increases a liability or decreases another asset, and vice-versa.’
10) Conservatism: This concept states that the accountant should not anticipate any income in advance and should provide for all probable losses. When there are alternatives available for measurement of assets, an accountant should choose the method which leads to a lesser value. The concept of – “cost or market value, whichever is lesser” originated from this concept only.
This concept states that the following three qualitative characteristics should be there in the financial statements, namely:
11) Consistency: The enterprise follows the same accounting policies from one period to another, until there is an exceptional circumstance, to achieve consistency and comparability of the financial statements.
The concept of consistency comes into picture when there are various alternatives available, e.g. Written Down Value (WDV) method or Straight Line method of charging depreciation. It is advisable to follow the same method of charging depreciation or valuation of inventories over the period to avoid confusion and inconsistency.
But, this concept doesn’t imply lack of flexibility; it allows some changes to improve the accounting practices. The changes can be made in any of the following circumstances:
(i)To comply with the Accounting Standards
(ii)To comply with the provision of law
(iii)When it is agreed that a new method can help reflect more true and fair picture in the financial statement.
12) Materiality: This concept is an exception of the full disclosure principle. It states that some aspects of the accounting can be ignored if it is not considered ‘material’. According to this principle, all the items having a material impact or significant economic effect on the business of the enterprise should be recorded and disclosed; other immaterial items can be ignored as it only increases the work of the accountant and is not relevant to the users of the accounts.
The term ‘materiality’ is a very subjective term. What is material to one firm may not be material for another based on the size and nature of the business. It is dependent on the judgement and discretion of an accountant that what he considers material and what he doesn’t for the entity.