Definition and Explanation:
Accounting is the language of business. Affairs of a business unit are made understood to others as well as to those who own or manage it through accounting information which has to be suitably recorded, classified, summarized and presented.
In order to make this language to convey the same meaning to all people, it is necessary that it should be based on certain uniform scientifically laid down standards. These standards are termed as accounting principles. Accounting principles may be defined as those rules of action or conduct which are adopted by the accountants universally while recording accounting transactions. In the absence of common principles there will be a chaotic situation and every accountant will have his own principles. Not only the utility of accounts will be less but these will not be comparable even in the same business. Therefore, it become essential that common principles should be followed for measuring business revenues and expenses.
Essential Features of Accounting Principles:
Accounting principles are accepted if they satisfy the following norms:
Usefulness:
A principle will be relevant only if it satisfies the needs of those who use it. The accounting principles should be able to provide useful information to its users otherwise it will not serve the purpose.
Objectivity:
A principle will be said to be objective if it is based on facts and figures. There should not be a scope for personal bias. If the principle can be influenced by the personal bias of users, it will not be objective and its usefulness will be limited.
Feasibility:
The accounting principle should be practicable. The principles should be easy to use otherwise their utility will be limited.
Accounting Concepts:
The term concepts includes those basic assumptions or conditions upon which accounting is based. The following are the important accounting concepts:
Business Entity Concept
Going Concern Concept
Money Measurement Concept
Cost Concept
Duel Aspect Concept
Accounting Period Concept
Matching Concept
Realisation / Realization Concepts
The explanation of these concepts are as follows:
Business Entity Concept:
In accounting, business is treated as separate entity from its owners. Accounts are prepare to give information about the business and not about those who own it. a distinction is made between business transactions and personal transactions. Without such a distinction, the affairs of the business will be mixed up with the private affairs of the proprietor and the true picture of the firm will not be available. The 'Business' and 'owner' are taken as two separate entities. The accountant is interested to record transactions relating to business only. The private transactions of the owner will be recorded separately and will have no bearing on the business transactions. All the transactions of the business are recorded in the books of the business from the point of view of the business as an entity and even the proprietor is treated as a creditor to the extent of his capital.
The concept of separate entity is applicable to all of business organizations. For example, in case of a sole proprietorship business or partnership business, though the sole proprietor or partners are not considered as separate entities in the eyes of law, but for accounting purposes they will be considered as separate entities. In the case of joint stock company, the business has a separate legal entity than the shareholders. The coming and going shareholders don not affect the entity of the business. Thus, the distinction between owner and the business unit has helped accounting in reporting profitability more objectively and fairly. It has also led to the development of 'responsibility accounting' which enables us to find out the profitability of even the different sub-units of the main business.
Going Concern Concept:
According to going concern concept it is assumed that the business will exist for a long time to come. Transactions are recorded in the books keeping in view the going concern aspect of the business unit. A firm is said to be going concern when there is neither the intention nor necessary to wind up its affairs. In other words, it should continue to operate at its present scale in the future. On account of this concept the fixed assets are shown in the balance sheet at a diminishing balance method i.e., going concern value. There is no need to show assets at market value because these have been purchased for use in future and earn revenues and for sale purpose. If the business is not to continue then market value will have significance. Since business is to continue, fixed assets will be shown at cost less depreciation basis. It is due to the concept that the fixed assets are depreciated on the basis of their expected life than on the basis of market value. The concept also necessitates distinction between expenditure that will render benefit over a long period and that whose benefit will be exhausted quickly, say within one year. The going concern concept also implies that existing liabilities will be paid at maturity.
Money Measurement Concept:
Accounting to records only those transactions which can be expressed in terms of money. Transactions or events which cannot be expressed in money do not find place in the books of accounts though they may be very useful for the business. For example, if a business has got a team of dedicated and trusted employees, it is definitely an asset to the business, but since their monetary measurement is not possible, they are not shown in the books of business. It should be remembered that money enables various things of diverse nature to be added up together and dealt with. The use of a building and the use of clerical service can be aggregated only through money values and not otherwise.
Cost Concept:
This concept is closely related to the going concern concept. According to this concept, an asset in ordinarily recorded in the books at the price at which it was acquired i.e., at its cost price. This cost serves the basis for the accounting of this asset during the subsequent period. The 'cost' should not be confused with 'value'. It must be remembered that as the real worth of the assets changes from time to time, it does not mean that the value of such an asset is wrongly recorded in the books. The book values of the assets as recorded do not reflect their real value. They do not signify that values noted therein are the values for which they can be sold. Though the assets are recorded in the books at cost, in course of time, they are reduced in value on account of depreciation charges. The idea that the transactions should be recorded at cost rather than at a subjective or arbitrary value is known as cost concept. With the passage of time, the market value of fixed assets like land and buildings vary greatly from their cost. These changes in the value are generally ignored by the accountants and they continue to value them in the balance sheet at historical cost. The principle of valuing the fixed assets at cost and not at market value is the underlying principle in cost concept. According to them the current values alone will fairly represent the cost to the entity. The cost principle is based on the principle of objectivity. There is no room for personal assessment in showing the figures in accounting records. If subjectivity is flowed in records the same assets will be valued at different figures by different individual. Every body will have his own views about various assets. The cost concept is helpful in making truthful records. The records becomes more reliable and comparable.
Dual Aspect Concept:
This is the basic concept of accounting. Modern accounting system is based on dual aspect concept. Dual concept may be stated as "for every debit, there is a credit". Every transaction should have two sided effect to the extent of same amount. For example, if A starts a business with a capital of $10,000. There are two aspects of the transaction. On the one hand the business has assets of $10,000 while on the other hand the business has to pay to the proprietor a sum of $10,000 which is taken as proprietor's capital. This expression can be shown in the form of following equation:
Capital (Equities) = Costs (Assets)
10,000 = 10,000
The term 'assets' denotes the resources owned by a business while the term 'equities' denotes the claims of various parties against the assets. Equities are of two types. They are owners equity and outsiders equity. Owner's equity (or capital) is the claim of the owner's against the assets of the business while outsiders equity (liabilities) is the claim of outside parties against the assets of the business. Since all assets of the business are claimed by someone (either owners or outsiders), the total of assets will be equal to total of liabilities. Thus:
Equities = Assets
OR Liabilities + Capital = Assets
Suppose if the business borrows $5000 from a bank, dual aspect of this transaction will be
Capital + Liabilities = Assets
A Loan
10,000 = 15,000
Thus the accounting Equation states that at any point of time the assets of any entity must be equal (in monetary terms) to the total of owner's equity and outsider's liabilities. As a mater of fact the entire system of double entry accounting is based on this concept.
Accounting period concept:
According to this concept, the life of the business is divided into appropriate segments for studying the results shown by the business after each segment. Since the life of the business is considered to be indefinite (according to going concern concept) the measurement of income and studying financial position of the business according to the above concept, after a very long period would not be helpful in taking proper corrective steps at the appropriate time. It is, therefore, absolutely necessary that after each segment or time interval the businessman must stop and see, how things are going on. In accounting such a segment or time interval is called accounting period. It is usually of a year.
At the end of each accounting period and income statement/profit & loss Account and a Balance Sheet are prepared. The income statement discloses the profit or loss made by the business during the accounting period while Balance Sheet discloses the financial position of the business as on the last day of the accounting period. While preparing these statements a proper distinction has to be made between capital and revenue expenditure.
Matching concept:
The aim of business is to earn profit. In order to ascertain the profit the costs (expenses) are matched to revenue. The difference between income from sales and costs of producing the goods will be the profit. When business is taken as a going concern then it becomes necessary to evaluate the performance periodically.
A correct statement of income requires a distinction between past, present and future expenditures. A distinction between capital and revenue expenditure is also necessary. The revenues and costs of same period are matched. In other words, income made by the business during a period can be measured only when the revenue earned during a period is compared with the expenditure incurred for earning that revenue. The question when the payment was received or made is irrelevant.
Realization Concept:
This concept emphasises that profit should be considered only when realised. The question is at what stage profit should be deemed to have accrued? Whether at the time of receiving the order or at the time of execution of the order or at the time of receiving the cash? For answering this question the accounting is in conformity with the law and Recognises the principle of law i.e., the revenue is earned only when the goods are transferred. It means that profit is deemed to have accrued when property i goods passes to the buyer, viz., when sales are made.
Accounting Conventions:
The term "conventions" includes those customs or traditions which guide the accountants while preparing the accounting statements. The following are the important accounting conventions.
Convention of Disclosure
Convention of Materiality
Convention of Consistency
Convention of Conservatism
Convention of Disclosure:
The disclosure of all significant information is one of the important accounting conventions. It implies that accounts should be prepared in such a way that all material information is clearly disclosed to the reader. The term disclosure does not imply that all information that any one could desire is to be included in accounting statements. The term only implies that there is to a sufficient disclosure of information which is of material in trust to proprietors, present and potential creditors and investors. The idea behind this convention is that any body who want to study the financial statements should not be mislead. He should be able to make a free judgment. The disclosures can be in the way of foot notes. Within the body of financial statements, in the minutes of meeting of directors etc.
Convention of Materiality:
It refers to the relative importance of an item or even. According to this convention only those events or items should be recorded which have a significant bearing and insignificant things should be ignored. This is because otherwise accounting will be unnecessarily over burden with minute details. There is no formula in making a distinction between material and immaterial events. It is a matter of judgment and it is left to the accountant for taking a decision. It should be noted that an item material for one concern may be immaterial for another. Similarly, an item material in one year may not be material in the next year.
Convention of Consistency:
This convention means that accounting practices should remain uncharged from one period to another. For example, if stock is valued at cost or market price whichever is less; this principle should be followed year after year. Similarly, if depreciation is charged on fixed assets according to diminishing balance method, it should be done year after year. This is necessary for the purpose of comparison. However, consistency does not mean inflexibility. It does not forbid introduction of improved accounting techniques. If a change becomes necessary, the change and its effect should be stated clearly.
Convention of Conservatism:
This convention means a caution approach or policy of "play safe". This convention ensures that uncertainties and risks inherent in business transactions should be given a proper consideration. If there is a possibility of loss, it should be taken into account at the earliest. On the other hand, a prospect of profit should be ignored up to the time it does not materialise. On account of this reason, the accountants follow the rule 'anticipate no profit but provide for all possible losses'. On account of this convention, the inventory is valued 'at cost or market price whichever is less.' The effect of the above is that in case market price has gone down then provide for the 'anticipated loss' but if the market price has gone up then ignore the 'anticipated profits.' Similarly a provision is made for possible bad and doubtful debt out of current year's profits.
Critics point out that conservatism to an excess degree will result in the creation of secrets reserves. This will be quite contrary to the doctrine of disclosure.
Accounting Equation:
Definition and Explanation of Accounting Equation:
Dual aspect may be stated as "for every debit, there is a credit." Every transaction should have twofold effect to the extent of the same amount. This concept has resulted in accounting equation which states that at any point of time the assets of any entity must be equal (in monetary terms) to the total of equities. In other words, for every business enterprise, the sum of the rights to the properties is equal to the sum of the properties owned. The properties of the business are called "assets". The rights to the properties are called "equities". Equities may be sub-divided into two principle types: The rights of the creditors and the rights of the owners. The equity of the creditors represents debts of the the business and are called liabilities. The equity of the owner is called capital, or proprietorship or owner's equity.
The formula know as the accounting equation, thus arrived at is as follows:
Assets = Equities
OR
Assets = Liabilities + Proprietorship
Another method of demonstrating the mathematical relationship involves a simple variation in the form of equation. Again it begins with the position that every business owns or has interest in certain assets. It also owes certain amounts to its creditors. The difference between what it owns and what it owes represents the owner's capital or proprietorship. Thus the original equation is changed into:
Assets - Liabilities = Proprietorship
Effects of Transactions on the Accounting Equation:
Each and every business transaction affects the elements of accounting equation. The effect is shown by the use of (+) or (-) placed against the elements affected. Note particularly that the equation remains in balance after each transaction. The accounting equation can be understood with the help of the following example:
Example:
Transaction 1:
Mr. Riaz commences his business with cash $50,000. This is an example of investment of asset in the business by the owner. The effect of this transaction on the accounting equation is that cash asset is increased by $50,000 and the proprietorship (Riaz's capital) is also increased by the same amount such as:
Assets = Liabilities + Proprietorship
Cash Riaz, Capital
+ 50,000 = ---- + 50,000
Note that assets and equities increased by equal amounts
Transaction 2:
Purchased furniture on cash $10,000. This transaction effected accounting equation as the increase in one new asset furniture and decreases in assets cash with the same amount. Thus
Assets = Liabilities + Proprietorship
Cash Furniture Riaz, Capital
+ 50,000 = ---- + 50,000
- 10,000 + 10,000
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40,000 + 10,000 = 50,000
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Note that this transaction has affected assets side only and no change is made in equities side of the equation.
Transaction 3:
Purchased merchandise for cash $10,000. This transaction will introduce a new element (merchandise) on the assets side and decrease the cash by $10,000.
Assets = Liabilities + Proprietorship
Cash Furniture Merchandise Riaz, Capital
+ 40,000 + 10,000 = ---- + 50,000
-10,000 -- + 10,000
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30,000 + 10,000 = 50,000
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Note that this transaction has affected assets side only and no change is made in equities side of the equation.
Transaction 4:
Purchased merchandise on account (on credit) $5,000.
Assets = Liabilities + Proprietorship
Cash Furniture Merchandise Creditors Riaz, Capital
+ 30,000 + 10,000 + 10,000 = + 50,000
+ 5,000 + 5,000
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30,000 +10,000 + 15,000 = + 5,000 + 50,000
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Note that this transaction has affected assets side and liabilities. Both the sides of equation has increased with the same amount.
Transaction 5:
Sold merchandise for cash $2,000 cost of these merchandise were $1,500.
Assets = Liabilities + Proprietorship
Cash Furniture Merchandise Creditors Riaz, Capital
+ 30,000 + 10,000 + 15,000 = + 5,000 + 50,000
+ 2,000 - 1,500 + 500 (Profit)
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+ 32,000 +10,000 + 13,500 = + 5,000 + 50,500
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Note that this transaction has affected assets side and also the proprietorship. Difference between sales price and cost price is treated as profit and has been added to capital.
Transaction 6:
Sold merchandise on credit for $4,000 costing $3,000.
Assets = Liabilities + Proprietorship
Cash Furniture Merchandise Debtors Creditors Riaz, Capital
+ 32,000 + 10,000 + 13,500 = + 5,000 + 50,500
- 3,000 + 4,000 + 1,000
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32,000 +10,000 + 10,500 + 4000 = + 5,000 + 51,500
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Note that this transaction has affected assets side and also the proprietorship. Anew element "debtors" has been introduced. Difference between sales price and cost price is treated as profit and has been added to capital.
Transaction 7:
Paid $1,000 to creditors for merchandise purchased.
Assets = Liabilities + Proprietorship
Cash Furniture Merchandise Debtors Creditors Riaz, Capital
+ 32,000 + 10,000 + 10,500 + 4,000 = + 5,000 + 51,500
- 1,000 - 1,000
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31,000 +10,000 + 10,500 + 4000 = + 4,000 + 51,500
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Transaction 8:
Received cash from a debtor $ 1,000 whom a sale on credit was made earlier. This is an example of collection from debtors. This transaction is an exchange of one asset for another. the effect is on one side of the equation, i.e., asset side. Thus:
Assets = Liabilities + Proprietorship
Cash Furniture Merchandise Debtors Creditors Riaz, Capital
+ 31,000 + 10,000 + 10,500 + 4,000 = + 4,000 + 51,500
+ 1,000 - 1,000
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32,000 +10,000 + 10,500 + 3000 = + 4,000 + 51,500
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Transaction 9:
Paid salaries $1,000 in cash. This transaction affected the equation by decrease in a cash asset and decrease in proprietorship (i.e., capital). Thus:
Assets = Liabilities + Proprietorship
Cash Furniture Merchandise Debtors Creditors Riaz, Capital
+ 32,000 + 10,000 + 10,500 + 4,000 = + 4,000 + 51,500
- 1,000 - 1,000
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31,000 +10,000 + 10,500 + 3000 = + 4,000 + 50,500
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Effects of all the transactions explained above are presented in the following table:
Assets = Liabilities + Proprietorship
Cash + Furniture + Merchandise + Debtors Creditors + Riaz, Capital
1 + 50,000 +50,000
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50,000 = + 50,000
2 - 10,000 + 10,000
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40,000 10,000 = + 50,000
3 - 10,000 + 10,000
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30,000 10,000 10,000 = + 50,000
4 + 5,000 + 5,000
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30,000 10,000 15,000 = 5,000 + 50,000
5 + 2,000 - 1,500 + 500 (Profit)
--------------------------------------------------------------------------------
32,000 10,000 13,500 = 5,000 + 50,500
6 - 3,000 + 4,000 + 1,000 (Profit)
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32,000 10,000 10,500 4,000 = 5,000 + 51,500
7 - 1,000 - 1,000
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31,000 10,000 10,500 4,000 = 4,000 + 51,500
8 +1,000 1,000
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32,000 + 10,000 + 10,500 + 3,000 4,000 + 51,500
9 1,000 1,000
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31,000 10,000 10,500 3,000 = 4,000 + 50,500
The elements of the equation of Mr. Riaz that is,
Cash + Furniture + Merchandise + Debtors = Creditors + Capital
31,000 + 10,000 + 10,500 + 3,000 = 4,000 + 50,500
This may also be stated in vertical form as shown below:
EQUITIES ASSETS
Creditors $4,000 Cash $31,000
Capital $50,500 Debtors 3,000
Merchandise 10,500
Furniture 10,000
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$54,500 $54,500
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The presentation of the effects of transactions in tabular form is only a device which helps beginners to understand the analysis of different types of transactions. It is not practically feasible to record the effects of transactions in this form. The increases and decreases in the various elements are recorded in the journal in a special technical form.
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