Financial AccountingAccounting Concepts

Underlying Accounting Concepts

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Accounting is the art of recording, summarizing, and reporting financial transactions and information. Like any other field of life, accounting also has some basic accounting concepts/ principles, which need to be followed while recording, summarizing, and reporting financial information. Account Concepts provide the rule about how transactions shall be recorded and reported into business books of accounts.

1. Separate Business Entity Accounting Concept

In accounting, a business (no matter how small) is considered a separate being, having its existing independent from its owners or persons managing it. All the transactions are recorded assumed as the record of business, no matter who is the second part of this transaction is.

All books of accounts record daily financial transactions from a business perspective rather than the owners. The amount provided by the owner of a business is recorded as cash inflow into a business, and will the source of that cash is recorded as a loan to the business by the owner.

The purpose of investment by the owners is usually to earn profits from the operations of the business. In accounting, the owners are considered lenders to the extent of the capital they invest into the business. If the owner puts cash into the business, he has a claim against the business for the amount of capital he has invested.

A Business is run by utilizing assets to earn revenue. A shopkeeper needs at least a counter and shelf to keep the inventory that he will sell to earn revenue. The Inventories and shelves are examples of assets. These assets are purchased, either by the money of the owner or he/ she will take a loan from someone else to finance the purchase of these assets.

For owners, the amount they paid as capital into a business is an investment made to earn profits, whereas for business it is a source of financing against owners’ claim over assets of the company.

Businesses and owners are treated separately because of the Separate Entity Concept. For example, when a person invests $ 10,000 in a business, it will be treated as if the business has borrowed so much from the owner and shown it as a ‘liability in the books of business accounts. Similarly, if the owner withdraws cash to incur some personal expenses, the amount (investment) resultantly, owned by him will be reduced.

However, this should be kept in mind that the law does not make such distinctions between owners and businesses in partnerships and sole proprietorships as in these business arrangements, under law, owners are liable to pay liabilities of their businesses. However, as far as a limited company is concerned, this difference is easily established because a company is a separate legal entity from its owners like a natural individual who can buy, sell, produce, lend, borrow and consume goods and employee services on his own. However, for sake of accounting and recording transactions, owners shall be treated separately, and in business book owners will be treated the same as lenders.

The separate business entity concept requires, the business is an independent entity from its managers and employees. Even the amounts paid to the manager and employee of the business are recorded as an expense (Salary).

The separate entity concept among other accounting concepts has a unique importance and is considered fundamental to all of the accounting processes.

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2. Dual Aspect Concept

According to the dual aspect concept, every business transaction has a dual effect and this duality of each transaction must be recorded. For example, if a firm sells goods for $500 in cash, the transaction involves two aspects. One aspect is the delivery of goods and the other aspect is instant receipt of cash.

In accounting, the dual effect of each transaction is recorded, and therefore the book-entry must indicate an increase or decrease in one item and a corresponding increase or decrease in another item. This way of recording a transaction affecting a double account is called double-entry accounting or bookkeeping.

Another implication of the double-entry concept means that the total amount of Assets shall always equal capital +Liabilities. (This is called the accounting equation and will be discussed later).

The total assets of a business are either financed by the financial resources provided by the owners or the sums of money borrowed from the creditors. Hence, any change in the value of one asset will result in a change of value in another class of asset or affect the value capital or liability.

Since double-entry requires an increase in one account means there is a parallel increase or decrease in another account. Practically an increase in one asset’s account will result in a decrease in the other asset or an increase in capital OR liability account. In over example of selling goods for $500, a decrease in goods (asset) resulted in an increase in cash (asset).

This idea is fundamental to accounting and can be expressed as the following equation:

Assets = Liabilities + Owners’ Equity; (1)

Owners’ equity = Assets – liabilities; (2)

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3. Matching Concept

According to the matching concept, the expenses incurred shall be matched to the revenue earned by incurring these expenses. The matching concept provides the fundamental bases for classifying expenses into capital expenditure (Assets) and revenue expenses.

Later in this chapter, we will explain the Matching Concept and its applications in detail.

4. Going Concern Concept

Financial statements are usually reported and presented with the assumption that the business will continue to work in foreseeable future. This means that all the assets will result in future economic flow during the normal course of operations in future.

The alternative assumption could be where a business might cease its operations in the coming future, in which case asset will be reported at its breakup values.

We will discuss the going concern assumption and its application in near future.

5. Prudence Concept

The Prudence concept requires that while making assumptions and recording transactions, extra cautions shall be exercised by the businesses. Assets shall not be overstated and liabilities shall not be understated. Similarly, if there is a probability of loss, it shall be immediately recorded as an expense against profit for the period. However, income shall not be recorded until it is not certain that economic benefits will flow to the entity.

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