Accounting Concepts and Assumptions
Accounting concepts are basic assumptions on the basis of which financial statements of a business are prepared. Accounting assumptions are broad concepts that develop GAAP (Generally Accepted Accounting Principles) upon which accounting is based. Certain ideas are assumed and accepted in accounting to provide uniform accounting practices. These uniform practices help the financial statements to be comparable both internally and externally leading to better analysis and interpretation of financial data.
|Are the universally accepted rules on the basis of which accounting practices take place. They serve as a guide for selection of conventions or procedures among different alternatives.|
|*Accounting Principles can be classified as concepts and conventions|
|Accounting Concepts||Accounting Conventions|
|Basic assumptions on the basis of which financial statements of a business are prepared.||Guidelines that arise from accounting practices, a.k.a. accounting principles.|
|These are the assumptions and conditions related to running a business.||These are the customs and traditions related to running a business.|
|Example: A Business is started with an assumption that the business unit will operate for a long period of time and will not be dissolved in the near future.||Example: A stock will be valued at the end of a period, at the cost or the market price, whichever is less.|
Business Separate Entity Concept
Also known as the Entity Concept. The essence of this concept is to consider a business as a separate entity different from the owner. It is an economic unit with its own identity. For the purpose of book-keeping we must keep the owners and their business separate. A business unit has its own assets and liabilities. This enables the accountants and the business to differentiate between transactions of a company and private transactions of the owners.
- Business and owners are different.
- A firm has its own assets and obligations.
- This makes it easy for accounting information users to segregate a transaction.
Example: Let us suppose there is a business started by Mr Unreal for 10,00,000 (1 Million) and he takes out 50,000 for his personal use. Now, if there was no separate entity concept, then the cash deduction would have ideally happened from the capital as an expenditure of the business itself. Now, with the business entity concept in place, the cash deduction is termed as “Drawings” and shown as a 3rd party (the owner in this case) is drawing money out of the capital. The balance sheet after the deduction will be shown as:
Going Concern Concept
The basic assumption in this case is that a business will operate for a long time and there is no reason why a business should be encouraged for a short period only to dissolve it in the near future. The assumption is termed as the Going Concern Concept. It is assumed that the business will not be dismissed in the near future. Financial statements are drawn with this assumption. The concept basically helps in distinction between long-term or short-term expenses and liabilities. In case this concept is not followed, it should be clearly mentioned in the financial statements along with the appropriate reasons.
- A strong assumption that an enterprise is a going concern and will continue operations for the foreseeable future.
- Helps determining short-term and long-term obligations of the business.
- A business needs to clearly provide reasons if it doesn’t agree with this assumption.
Example: Let us take the same example as previously used where Mr Unreal had invested 10,00,000 in his business. Mr Unreal purchased a vehicle for 2,00,000 before the end of the financial year. Now, if Mr Unreal decided not to follow the going concern assumption and sell off his business, the financial situation might be different due to loss or profit on the sale of the asset. He might have less money in hand after selling off the vehicle. If the going concern is assumed, then the increase or decrease in the value of the asset in the short-term is ignored. Now, if Mr Unreal follows the going concern concept, the financial situation of the business at the beginning of the next financial period will be as follows:
Money Measurement Concept
All transactions of a business are recorded in terms of money. According to this concept, only transactions which can be recorded in terms of money are recorded. In other words, an event or a transaction that can’t be expressed in terms of money can’t be recorded in the books of accounts. The reason for this is that money provides a uniform way to measure the value of goods and services.
- If it has to go in the accounting books, it has to be measurable in terms of money.
- The concept has its limitations and inadequacies.
Example: 5 Trucks, 300 kg of raw material, 10 tables and 5 Chairs all make no sense to be mentioned in the books.
There are 2 major flaws with this concept:
- It assumes stability in the value of money, i.e. it doesn’t account for inflation.
- Many factors of vital performance are outside the purview of accounting.
Also called the Concept of definite Accounting Period. According to this concept, the life of a business is broken into smaller periods called accounting periods so that the performance can be measured at fixed intervals. An accounting period could be a year, half-year or even a quarter. It could be said that the business is here to stay for a long time, according to the going concern concept. So, the financial statements of the enterprise should be prepared at the end of its life. It is possible, but not practical as the users of financial statements need the information at regular intervals, so that decisions can be taken in a timely fashion.
- Even though the life of a business is considered indefinite (according to the going concern concept) it still needs to be divided into equal intervals for accounting purposes.
- An accounting period is usually one year and is called the accounting year.
Example: Let’s assume that if a financial company lasts for 150 years, it is impractical and undesirable to measure its performance and financial position at the end of 150 years. Therefore, the life of the company is divided into equal intervals to measure the financial position of the business. The periodicity concept results in the following benefits:
- Comparing financial positions at different intervals.
- Proper matching of periodic revenues and expenses to meet the objectives of accounting.
- Consistent accounting treatment to find out profit and valuation of assets.
According to this concept, a transaction is recorded in the books of accounts at the time of their occurrence and not when the actual cash or a cash equivalent is received or paid. The profit earned or the loss incurred for a period is the result of both cash and credit transactions, hence it is possible that certain incomes are earned but not received and, similarly, certain expenses are incurred but not yet paid during an accounting period. It is relevant to consider them while working out the financial results, only because they are related to the concerned accounting period.
- It doesn’t matter when the cash is paid or received. A transaction is recorded at the time of its occurrence.
- Profit is said to be earned at the time the goods or services are sold to a customer, i.e. a legal title of the goods is passed to the customer.
Example: On December 31, 2013, the interest receivable on a fixed deposit was 1000 (assuming that the accounting year was to be closed on December 31, 2013). The interest amount was deposited in the bank on January 12, 2014. According to the accrual concept, the income of 1000 from the interest on the fixed deposit belongs to the year 2013 and not 2014, even though the cash was actually received in 2014. The same applies to the expenses. Four important scenarios that emerge due to accrual concept are:
- Prepaid expense
- Outstanding expense
- Accrued Income
- Income received in advance