- 1 What is the Basic Accounting Concepts?
- 2 The importance of Basic Accounting Concepts
What is the Basic Accounting Concepts?
Basic Accounting Concepts- The fundamental ideas or basic assumptions underlying the idea and practice of monetary accounting and are broad working rules for all accounting activities and developed by the accounting profession, It’s called basic accounting concepts.
The importance of Basic Accounting Concepts
• Business entity
• Money measurement
• Going concern
• Accounting period
• Dual aspect (or Duality)
• Revenue recognition (Realization)
• Full disclosure
• Conservatism (Prudence)
The main basic accounting concepts are an idea of an enterprise entity assumes that a commercial enterprise has an awesome and separate entity from its owners. It is an ability that for the functions of accounting, the business and its proprietors are to be dealt with as two separate entities. Keeping this in view, when a man or woman brings in some cash as capital into his business, in accounting records, it is dealt with as legal responsibility of the enterprise to the owner.
Here, one separate entity (owner) is assumed to be giving cash to any other wonderful entity (business unit). Similarly, when the proprietor withdraws any cash from the enterprise for his personal expenses(drawings), it is handled as the discount of the owner’s capital and for this reason a reduction in the liabilities of the business. The accounting documents are made in the book of bills from the factor of view of the enterprise unit and no longer that of the owner.
The non-public property and liabilities of the proprietor are, therefore, now not viewed whilst recording and reporting the assets and liabilities of the business. Similarly, non-public transactions of the owner are now not recorded in the books of the business, except it includes influx or outflow of commercial enterprise funds.
The Basic accounting concept of cash measurement states that only those transactions and happenings in a corporation which will be expressed in terms of cash like the sale of products or payment of expenses or receipt of income, etc. are to be recorded within the book of accounts. All such transactions or happenings which can not be expressed in monetary terms, as an example, the appointment of a manager, capabilities of its human resources or creativity of its research department or image of the organization among people, generally, don’t find a neighborhood within the accounting records of a firm.
Another important aspect of the essential accounting concept of money measurement is that the records of the transactions are to be kept not within the physical units but the unit of measurement. for instance, a corporation may, on a specific day, have a factory on a bit of land measuring 2 acres, an office block containing 10 rooms, 30 personal computers, 30 office chairs and tables, a bank balance of Rs.5 lakh, staple weighing 20-tons, and 100 cartons of finished goods. These assets are expressed in several units, so cannot be added to supply any meaningful full information about the whole worth of business.
For accounting purposes, therefore, these are shown in money terms and recorded in rupees and Paise. during this case, the worth of factory land may be said Rs. 2 crores; office block Rs. 1 crore; computers Rs.15 lakh; office chairs and tables Rs. 2 lakh; staple Rs. 33 lakh and finished goods Rs. 4 lakh. Thus, the entire assets of the enterprise are valued at Rs. 3 crore and 59 lakh. Similarly, all transactions are recorded in rupees and paise as and once they happen.
The money measurement assumption isn’t free from limitations. thanks to the changes in prices, the price of money doesn’t remain the same throughout some time. the worth of the rupee today on account of rising in prices is far but what it had been, say ten years back.
Therefore, within the record, once we add different assets bought at different points of some time, say building purchased in1995 for Rs. 2 crores, and plant purchased in 2005 for Rs. 1 crore, we are literally adding heterogeneous values, which can not be clubbed together. because the change within the worth of money isn’t reflected within the book of accounts, the info doesn’t reflect truth and fair view of the affairs of an enterprise.
He thought of going problem assumes that a billboard enterprise association would proceed to hold out its operations indefinitely, i.e. for a reasonably long duration of your time, and wouldn’t be liquidated within the foreseeable future. This is an important assumption of accounting because it offers the very groundwork for displaying the fee of belongings within the record. An asset also can be described as a bundle of services.
When we buy an asset, for instance, a personal computer, for a sum of Rs. 50,000, what we are buying simply is that the offerings of the pc that we shall be getting over its estimated lifestyles span say 5 years. It will not be truthful to cost the entire quantity of Rs. 50,000, from the income of the 12 months during which the asset is purchased. Instead, that section of the asset which has been eaten up or used during a length should be charged from the income of that period.
The assumption associated with continuity of enterprise permits us to cost from the revenues of a length solely that phase of the asset which has been eaten up or used to earn that income therein period and lift before the ultimate quantity to the next years, over the estimated lifetime of the asset.
Thus, we might also cost Rs. 10,000 every 12 months for five years from the profit and loss account. In case the continuity assumption is not any longer there, the entire cost (Rs. 50,000 within the existing example) will want to be charged from the revenue of the yr during which the asset was once purchased.
In the basic accounting concepts, and accounting period refers to the span of your time at the top of which the financial statements of an enterprise are prepared, to understand whether it’s earned profits or incurred losses during that period and what exactly is that the position of its assets and liabilities at the top of that period. Such information is required by different users at regular intervals for various purposes, as no firm can await long to understand its financial results as various decisions are to be taken at regular intervals to support such information.
The financial statements are, therefore, prepared at a daily interval, normally after a period of 1 year, so that timely information is formed available to the users. This interval of time is called an accounting period.
The Companies Act 2013 and therefore the tax Act require that the income statements should be prepared annually. However, within the case of certain situations, preparation of interim financial statements become necessary. For example, at the time of retirement of a partner, the accounting period is often different from twelve months period. Apart from these companies whose shares are listed on the stock market, are required to publish quarterly results to determine the profitability and financial position at the top of every three months.
The cost concept requires that each one asset is recorded within the book of accounts at their price, which incorporates the value of the acquisition, transportation, installation and makes the asset ready to use.
To illustrate, in June 2005, an old plant was purchased for Rs. 50 lakh by Shiva Enterprise, which is within the business of producing detergent powder. An amount of Rs. 10,000 was spent on transporting the plant to the factory site. Besides, Rs. 15,000 was spent on repairs for bringing the plant into running position, and Rs. 25,000 on its installation. The total amount at which the plant is going to be recorded within the books of account would be the sum of these, i.e.Rs. 50,50,000.
The concept of cost is historical in nature because it is some things, which have been paid on the date of acquisition and don’t change year after year. For example, if a building has been purchased by a firm for Rs. 2.5 crore, the acquisition price will remain an equivalent for all years to return, though its market price may change. Adoption of historical cost brings objectivity in recording because the value of the acquisition is certainly verifiable from the acquisition documents. The market price basis, on the opposite hand, isn’t reliable because the value of an asset may change from time to time, making the comparisons between one period to another rather difficult.
However, a crucial limitation of the historical cost basis is that it doesn’t show the true worth of the business and should cause hidden profits. During the amount of inflation, the market price or the worth at (which the assets are often replaced is above the value at which these are shown in the book of accounts) leading to hidden profits.
The dual aspect is that the foundation or fundamentals of accounting. It provides the very basis for recording business transactions into the book of accounts. This concept states that each transaction features a dual or two-fold effect and will therefore be recorded at two places.
In other words, a minimum of two accounts is going to be involved in recording a transaction. This can be explained with the assistance of an example. Ram started a business by investing a sum of Rs. 50,00,000 the quantity of cash brought in by Ram will end in a rise within the assets (cash) of business by Rs. 50,00,000. At an equivalent time, the owner’s equity or capital also will increase by an equal amount. It may be seen that the 2 items that got suffering from this transaction are cash and capital account.
Let us take another example to know now further. Suppose the firm purchases goods worth Rs. 10,00,000 on cash. This will increase an asset (stock of goods) on the one hand and reduce another asset (cash) on the opposite. Similarly, if the firm purchases a machine worth Rs. 30,00,000 on credit from Reliable Industries. This will increase an asset (machinery) on the one hand and a liability (the creditor) on the opposite.
This type of dual effect takes place in the case of all business transactions and is also known as the duality principle. The duality principle is commonly expressed in terms of fundamental Accounting Equation, which is as follows :
Assets = Liabilities + Capital
In other words, the equation states that the assets of a business are always equal to the claims of owners and outsiders. The claims also called equity of householders is termed as capital(owners’ equity) which of outsiders, as Liabilities(creditors equity). The two-fold effect of every transaction affects in such a fashion that the equality of each side of the equation is maintained
The two-fold effect in respect of all transactions must be duly recorded in the book of accounts of the business. In fact, this idea forms the core of the double-entry bookkeeping system of accounting.
Revenue recognition (Realization)
The idea of income focus requires that the income for a business transaction got to be blanketed within the data solely when it’s realized. Here arise two questions in mind. The first is termed as income and the other is when the income is realized.
Let us take the first one first. Revenue is that the gross influx of cash arising from (i) the sale of things and offerings by using an enterprise; and (ii) use through others of the enterprise’s sources yielding interest, royalties, and dividends.
Secondly, income is assumed to be realized when a legal proper to obtain it arises, i.e. the factor of your time when items are sold or provider has been rendered. Thus, deposit income is addressed as income on the day income is made and not when cash is acquired from the customer.
As for the income like rent, commission, interest, etc., these are recognized on a time basis. For example, the lease for March 2017, even if obtained in April 2017, will be taken into the earnings and loss account of the monetary year ending March 31, 2017, and no longer into the economic yr starting with April 2017.
Royalties and dividends. Secondly, income is assumed to be realized when a legal proper to obtain it arises, i.e. the factor of your time when items are sold or provider has been rendered. Thus, deposit income is addressed as income on the day income are made and not when cash is acquired from the customer. As for the income like rent, commission, interest, etc., these are recognized on a time basis.
For example, the lease for March 2017, even if obtained in April 2017, will be taken into the earnings and loss account of the monetary year ending March 31, 2017, and no longer into the economic yr starting with April 2017.
The manner of ascertaining the quantity of income earned or the loss incurred during a precise duration entails deduction of associated charges from the revenue earned in the course of that period. The matching idea indicates exactly this aspect. It states that costs incurred in an accounting length should be matched with revenues at some point of that period. It follows from this that the revenue and charges incurred to earn these revenues ought to belong to the same accounting period.
As already stated, income is regarded when a sale is whole or a service is rendered instead of when money is received. Similarly, a rate is recognized not when money is paid but when an asset or carrier has been used to generate revenue. For example, costs such as salaries, rent, insurance plans are recognized on the groundwork of duration to which they relate and no longer when these are paid. Similarly, costs like the depreciation of a constant asset are divided over the duration in the course of which the asset is used.
Let us also understand how the cost of goods is matched with their sales revenue. While ascertaining the profit or loss of an accounting year, we should not take the cost of all the goods produced or purchased during that period but consider only the cost of goods that have been sold during that year. For this purpose, the cost of unsold goods should be deducted from the cost of the goods produced or purchased. You will learn about this aspect in detail in the chapter on a financial statement.
The matching concept, thus, implies that all revenues earned during an accounting year, whether received during that year or not, and all costs incurred, whether paid during the year or not should be taken into account while ascertaining profit or loss for that year.
Information furnished by way of economic statements is used by using specific organizations of people such as investors, lenders, suppliers, and others in taking various financial decisions. In the company shape of the organization, there is a difference between managing the affairs of the business enterprise and these proudly owning it.
Financial statements, however, are the only or simple capacity of communicating financial statistics to all or any fascinated parties. It turns into all the greater importance, therefore, that the monetary statements make a full, truthful, and adequate disclosure of all data which is applicable for creating monetary decisions.
The precept of full disclosure requires that each one cloth and applicable facts concerning the monetary overall performance of a commercial enterprise need to be entirely and completely disclosed within the economic statements and their accompanying footnotes. This is to permit the purchasers to form the proper evaluation about the profitability and financial soundness of the agency and assist them to form knowledgeable decisions.
To make sure applicable disclosure of fabric accounting information, the Indian Companies Act 1956 has supplied a layout for the practice of earnings and loss account and stability sheet of a company, which wishes to be compulsorily adhered to, for the education of these statements. The regulatory bodies like SEBI, also mandate whole disclosures to be made by way of the companies, to give a proper and truthful view of profitability and the country of affairs.
The accounting records furnished with the help of the monetary statements would be useful in drawing conclusions associated with the working of an employer only it allows comparisons over a duration of time as nicely as with the working of other enterprises. Thus, each inter-firm and inter-period comparison are required to be made. This can be feasible solely when accounting insurance policies and practices amid means of companies are uniform and are steady over the amount of your time.
To illustrate, an investor must understand the monetary overall performance of an enterprise within the contemporary 12 months as in contrast thereto within the preceding year. He may evaluate this year’s internet income thereupon within the remaining year. But, if the accounting insurance policies adopted, say with recognition to depreciation within the two years are different, the earnings figures will not be comparable. Because the tactic adopted for the valuation of inventory within the previous two years is inconsistent.
It is, therefore, vital that the notion of consistency is accompanied in the preparation of monetary statements so that the effects of two accounting durations are comparable. Consistency eliminates private bias and helps in accomplishing comparable results.
The idea of conservatism (also known as ‘prudence’) presents practice for recording transactions in the book of money owed and is based totally on the coverage of enjoying safe. The thought states that a mindful strategy must be adopted in ascertaining income so that the earnings of the organization are now not overstated. If the income ascertained are greater than the actual, it may additionally lead to the distribution of dividend out of capital, which is no longer truthful as it will lead to a discount in the capital of the enterprise.
The concept of conservatism requires that income must no longer be recorded until realized however all losses, even those which may additionally have a far-flung possibility, are to be supplied for in the books of account. To illustrate, valuing the closing stock at price or market price whichever is lower; growing provision for doubtful debts, bargain on debtors; writing of intangible property like goodwill, patents, etc. from the book of money owed are some of the examples of the utility of the precept of conservatism.
Thus, if the market price of the items purchased has fallen, the inventory will be proven at a value fee in the books however if the market fee has long passed up, the reap is no longer to be recorded till the inventory is sold. This method of supplying for the losses however now not recognizing the good points until realized is known as the conservatism approach. This may also be reflecting a general pessimist mindset adopted with the aid of the accountants however is a vital way of dealing with uncertainty and defending the pursuits of lenders in opposition to an unwanted distribution of a firm’s assets. However, deliberate strive to underestimate the cost of belongings ought to be discouraged as it will lead to hidden profits, referred to as secret reserves.
The concept of materiality requires that accounting must center attention on material facts. Efforts need not be wasted in recording and imparting facts, which are immaterial within the willpower of income. The query that arises right here is what’s a cloth fact.
The materiality of reality relies upon its nature and the amount involved. Any truth would be considered cloth if it’s reasonably believed that its understanding would affect the selection of the knowledgeable person of monetary statements. For example, cash spent on the introduction of additional capacity of a theatre would be a cloth reality because it goes to form bigger the power of the future income of the enterprise.
Similarly, data about any change within the approach of depreciation adopted or any liability which is perhaps to arise within the on the brink of the future would be giant information. All such information about cloth data needs to be disclosed thru the monetary statements and therefore the accompanying notes so that customers can make knowledgeable decisions.
In certain cases, when the number of worries is extremely small, strict adherence to accounting principles is not required. For example, inventory of erasers, pencils, scales, etc. is no longer proven as assets, something quantity of stationery is obtainable in an accounting length is addressed because the fee of that period, whether or not consumed or not. The quantity spent is addressed as income expenditure and brought to the profit and loss account of the yr during which the expenditure is incurred.
The concept of objectivity requires that accounting transactions need to be recorded in a goal manner, free from the bias of accountants, etc. This can be feasible when every transaction is supported via verifiable documents or vouchers. For example, the transaction for the buy of drugs may additionally be supported through the cash receipt for the cash paid, if the equation is bought on cash or replica of the bill and transport challan, if the equation is bought on credit.
Similarly, the receipt for the quantity paid for the buy of a computing device turns into the documentary proof for the price of the computer and gives a goal basis for verifying this transaction. One of the motives for the adoption of ‘Historical Cost’ as the groundwork of recording accounting transactions is that adherence to the principle of objectivity is made feasible through it. As mentioned above, the fee actually purchased an asset is often proven from the files however it’s very hard to determine the market value of an asset till it is certainly sold. Not solely that, the market value can also fluctuate from character to character and from region to put, then ‘objectivity’ cannot be maintained if such cost is adopted for accounting purposes.
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