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Study Note 2: Accounting Principles

This study note focuses on various accounting concepts that should be understood before
learning the accounting mechanism.
Business entity concept
The legal entity of a corporate business is distinct from the entity of its owners and managers,
and the people understand it well. Less understood, however, is that the accounting entity of a
business is distinct from its owners. For example, for many business purposes legal entity of
a sole-proprietary business may not be very distinct from the entity of the proprietor himself.
However, the business entity concept requires that this should not come in the way of treating
the business as a distinct accounting entity for the purpose of treating transactions relating to
the operations of the business. It is in accordance with this concept that when and on a brings
capital into the business, the business intern is DM to O the capital to the owner. Again,
coming to the business between the sole-proprietary concern and its sole proprietor, usually,
the proprietor may not be himself a salary even when he works for his business. However, in
accordance with the business as a separate entity, his position as an owner may not come in
the way the office charges a salary to the business for the services rendered by him. This is
because, as far as the business is concerned, the services rendered cannot be regarded as cost-
free. The reward of ownership is manifested only in profit, which must be arrived at after
charging all the costs.
Going Concern
A business entity is assumed to carry on its operations forever. Even if all the members of the
management die, the concern will continue to exist. Going Concern concept implies that the
resources of the concern should be used for the purpose of business which they are meant to
be used. The concept of employees that land, building, machinery, etc. Which are required
for carrying out the production and selling of certain products, should continue to be a
concern for a long time.

Cost concept
The cost concept implies that in accounting, all transactions are generally recorded at cost
and not at market value. For example, if a piece of land is acquired for 2lac, it would continue
to be shown in the balance sheet at Rs.200000 even when the market value of the land rises
to, say, Rs. 5lacs. The cost concept is closely related to Going Concern Concept. Suppose the
land is acquired for operations of the business and would continue to be used for its
operations and would not be sold shortly. In that case, it is mainly in material what the land’s
market value is since it will not be sold anyway. Thus, it is consistent with the going concern
concept to keep recording the land at a cost of 2 lacs on an ongoing basis.

Money Measurement Concept

All transactions are recorded through a common denominator, namely the monetary unit.
Thus, if a certain event cannot be measured in monetary terms, no matter how significant it is

Curated by: Poonam Namjoshi TRI1:FRA

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for the help of or even the existence of the business, it cannot be recorded in the books of
accounts. For example, the purchase of an inconsequential asset such as tables and chairs,
which is easily method in rupee terms, is accounted for in the business; however, the
retirement or death of a chairman of a company has far-reaching consequences for the health
of the business. It is not accounted for since no monetary measurement for the event is
feasible.
Duality or double entry concept
This concept states that for every transaction, there will be two aspects. For example, when
capital is introduced into business, there is cash inflow, capital forms a liability, and the cash
inflow is an asset. Similarly, when equipment is purchased for cash, the new asset comes in
(use of funds), and cash will decrease (source of funds). Or, when the equipment is purchased
for credit, the new asset comes in, and a liability will occur. For every transaction, there are
two aspects. In effect, all transaction affects the basic accounting equation given under
Assets = Liabilities + Owners' equity

Accounting period concept

To be able to prepare income statements for business, the period for which it is to be prepared
must be specified. An Accounting Period may be a calendar year or a financial year. In some
businesses, such as trading, the operating period may be relatively short, say a month or even
less in other cases it may stretch well beyond the year. Under the Companies Act, a company
usually is not permitted to have the accounting period extending beyond 15 months.

Matching concept
In order to determine the profits or losses accrued in an accounting period, the expenses must
relate to the goods and services sold during the period. The expenses incurred in producing
goods and services should be matched to the revenue realised from selling goods and
services.
Conservatism concept
The idea behind this concept is that revenue recognition requires better evidence than
recognition of expenses. The concept emphasises that revenues are recognised only when
they are reasonably, certain, and expenses are to be recognised as soon as possible. For
example, a sales manager might have finalised the deal with the client to sell 100 units of a
product. But unless this item is produced and delivered to the client, there is no reasonable
certainty about receiving the payment for those hundred units. It is only thereafter that he can
record the sales amount on those hundred units as due from the client. On the other hand, if
you come to know that the customer has lost all his Assets and it is likely to default payment,
then we should immediately either make probation for sex losses or write them off.
Consistency concept

Curated by: Poonam Namjoshi TRI1:FRA

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The consistency concept requires that once an entity has decided on one method, it will treat
all subsequent events of the same character in the same fashion unless it has sound reason to
change the treatment method of that event. For example, if a concern is charging depreciation
by one method, it is expected to follow the same method in subsequent years also.
Materiality concept
All financial transactions need to be recorded in books of accounts; however, there may be
transactions that may be insignificant and are not shown separately. They are usefully club
with others. There is no agreement as to the exact line separating the material events from the
material events. The decision depends on judgements and common sense.
Realisation concept
According to this concept, revenues are recognised only when goods and services have been
delivered, and there is certain that revenue will be realised. If, from past experience, it is
realised that revenue is realised for 95% of the sales, a provision of 5% can be treated as a
doubtful account. For example, orders may be obtained at time 1, which may be accepted at
time 2, the work towards the production of an order may commence at time 3, the production
process is completed at time 4, the goods are dispatched at time 5, and the cash is received at
time 6, and so on. At which time can one say that revenue is realised, or a sale is made?
Normally, revenue is said to be realised when efforts are rendered or rewarded either in cash
or kind or in the form of a promise of reward sometime in future. Now, in the above context,
a reward or a promise of reward sometime in future may normally forthcoming only after
goods are dispatched. Thus, revenue is normally recognised only when goods or services are
transferred, and a reward or a promise of reward is forthcoming. If there is no transfer of
goods or services normally, no reward may be expected either now or in the future, and no
revenue will be realised. Similarly, there is no reward or a promise of reward in return for
goods or services nearly B and act of philanthropy or squandering and cannot be construed as
a "Sale". Thus, usually, revenue is recognised at the time of transfer of goods or services
respective whether payment is made immediately or in future. However, there are exceptions
to the rule of revenue recognition.

Curated by: Poonam Namjoshi TRI1:FRA