PART -1

ACCOUNTING CONCEPTS
 Introduction to accounting

Accounting Concepts

1.1 Definition of Accounting Concept

Accounting Concepts can be understood as the basic accounting assumption, which acts as a
foundation for the preparation of financial statement of an enterprise. Indeed, these form a
basis for formulating the accounting principles, methods and procedures, to record and present
the financial transactions of business.

These concepts provide an integrated structure and rational approach to the accounting
process. Every financial transaction that occurs is interpreted taking into consideration the
accounting concepts, which guides the accounting methods.

1.2 Important Concepts in Accounting

Accounting bodies classify concepts as based on assumptions or based on principles. Every type
of business—including a sole proprietorship, partnership or a public or private company—
records its financial transactions based on these assumptions and principles. These are some of
the important concepts in accounting:

1. Business entity concept:

The business entity, economic entity or separate entity concept assumes that a business is
independent of its owner. A business may not record its owner's personal expenses, income,
liabilities and assets. It aids in tracking a business's expenses, incomes and tax deductions
without any ambiguity. In addition, it safeguards a business owner's personal finances and
helps build their creditworthiness. It reflects cash flow and financial position more accurately.
This clear distinction helps stakeholders and creditors take appropriate business decisions
based on a company's performance rather than the owner's financial position.

2. Going concern concept:

Going concern concept prescribes that accountants prepare financial statements on the
assumption that a business may continue its operations for the foreseeable future. Under this

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concept, the definition of a foreseeable future is a period of 12 months from the end date of
the reporting period. If a business owner or the management is invested in scaling down
business operations to zero, they cannot apply the going concern concept for accounting.
Accountants may no longer apply the going concern concept if a company is:

 unable to pay dividends

 unable to raise credit from banks and financial services

 facing losses and negative operating cash flow

 facing an adverse financial position

 unable to pay back crucial debts

 facing an unfavorable legal or regulatory action against it

3. Money measurement concept:

This is an accounting concept based on assumption, and it stipulates that companies record
only those transactions that they can quantify and measure in terms of money. If they cannot
assign a monetary value to a transaction, they do not record it in their annual financial
statement. Though these transactions affect a company's financial performance, they may not
find a place in financial statements, as monetizing them can be challenging. Some examples of
non-monetary value include employee competence, product quality, employee efficiency,
market sentiment, business productivity and stakeholder satisfaction.

4. Accounting period concept:

The accounting period concept prescribes a timeframe within which a business records and reports
its financial performance for the purview of internal and external stakeholders. An accounting period of
a company may coincide with the fiscal year. A company can determine a timeframe for internal
reporting, like three or six months, or prepare monthly financial reports to analyze their cash flow
positions. The management can determine a convenient accounting period for internal reporting, but
the reporting for investor, government and tax purposes is typically for the period of one year.

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5. Accrual concept:
Accrual is a fundamental concept that guides how a business can record cash or credit
transactions. Under this concept, a business records a financial transaction in the period it
occurs. It does not consider whether the business pays or receives cash at the time of the
transaction, or if it pays cash after a certain period. For example, a company records a credit
purchase at the time of purchase rather than when it pays back the seller. This helps record and
report income, expenses, liabilities and receivables accurately. All modern accounting systems
follow the accrual concept in recording financial transactions.

6. Revenue realization concept:

Under the revenue realization or revenue recognition concept, seller records potential revenue from
a transaction, regardless of whether they have or have not received proceeds. The ownership of a
product transfers from a buyer to a seller during a sale. A seller recognizes the transaction by creating a
receivable against the buyer's name in their ledger. An accountant creates another entry when they
receive the due amount in the future.

7. Dual aspect concept:

Dual aspect concept states that every transaction affects two accounts of a business. A
business then records both aspects to enable accurate accounting. Every financial transaction
has a credit or debit or a giver or receiver aspect. If an accounting process does not represent
both, it may lead to faults in the final accounting record. The dual aspect concept is the
foundation of the double-entry system of bookkeeping, which is now a standard method for
auditing and taxation.

8. Cost concept:
This concept holds that all the assets of the enterprise are recorded in the accounts at their
purchase price. The cost concept states that a business may record assets and liabilities at their
cost rather than their current market or sale value. It helps to maintain consistent, reliable and
verifiable financial information. Including the current value of an entity can result in financial
irregularities.

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9. Matching concept:
Matching concept is an accounting principle that requires companies to match their expenses
with the revenue they generate in the same accounting period. It means that expenses incurred
to generate revenue should be recognized in the same period as the revenue, regardless of
when the cash is received or paid.

This concept is important because it helps to ensure that a company's financial statements
accurately reflect its profitability and financial health. By matching expenses with the revenue
they generate, companies can provide a more accurate picture of their financial performance,
including the cost of producing goods or services.

1.3 Methods of Accounting Concepts

There are two main methods of accounting concepts: cash basis accounting and accrual basis
accounting.

1. Cash Basis Accounting: This method of accounting recognizes revenue and

expenses when cash is received or paid. In other words, revenue is recognized when
cash is received, and expenses are recognized when cash is paid. This method is often
used by small businesses, sole proprietors, and freelancers who do not have complex
accounting needs.

Advantages of cash basis accounting:

1. Simplicity: Cash basis accounting is a simple and straightforward method of accounting

that is easy to understand and implement. It requires minimal record-keeping and is
ideal for small businesses that have few transactions.

2. Cash flow management: Cash basis accounting provides a clear picture of a business's
cash flow, which can be important for managing working capital and making decisions
about investments or financing.

3. Reduced accounting fees: Since cash basis accounting requires less record-keeping and
is easier to understand, it can reduce accounting fees for small businesses.

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Disadvantages of cash basis accounting:

1. Incomplete picture of financial performance : Cash basis accounting provides an

incomplete picture of a company's financial performance since it does not take into
account revenue or expenses that have been earned or incurred but have not yet been
paid or received.

2. Inaccurate reflection of financial position: Cash basis accounting may not accurately
reflect a company's financial position since it does not include accounts payable or
accounts receivable.

3. Limited usability: Cash basis accounting is not suitable for large businesses or those with
complex operations since it provides limited financial information.

4. Noncompliance: Some countries or regulatory bodies may require businesses to use

accrual basis accounting rather than cash basis accounting, which can lead to
noncompliance and potential legal issues.

In summary, cash basis accounting is a simple and straightforward method of accounting

that is ideal for small businesses with few transactions. However, it provides an
incomplete picture of financial performance and may not accurately reflect a company's
financial position. Therefore, it may not be suitable for larger businesses or those with
complex operations.

2. Accrual basis accounting: This method of accounting recognizes revenue and

expenses when they are earned or incurred, regardless of when cash is received or paid.
In other words, revenue is recognized when it is earned, even if payment has not yet
been received, and expenses are recognized when they are incurred, even if payment
has not yet been made. This method is often used by larger businesses and corporations
with more complex accounting needs.

Advantages of Accrual Basis Accounting:

1. More accurate picture of financial performance : Accrual basis accounting provides a

more accurate picture of a company's financial performance since it recognizes revenue

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and expenses when they are earned or incurred, rather than when cash is received or
paid.

2. Better matching of revenue and expenses: Accrual basis accounting allows for better
matching of revenue and expenses, which can provide a clearer understanding of a
company's profitability and help with budgeting and planning.

3. Improved decision-making: Accrual basis accounting provides a more complete and

reliable picture of a company's financial position, which can improve decision-making by
management, investors, and lenders.

4. Better compliance: Accrual basis accounting is often required by regulatory bodies and
is generally accepted by the accounting profession, which can help businesses stay in
compliance with legal and accounting standards.

Disadvantages of Accrual Basis Accounting:

1. Complexity: Accrual basis accounting is more complex than cash basis accounting, and it
requires more record-keeping and accounting expertise.

2. Timing issues: Accrual basis accounting may create timing issues, as revenue and
expenses may be recognized in different periods than when cash is received or paid.

3. Potential for manipulation: Accrual basis accounting can be more easily manipulated
than cash basis accounting, which can lead to fraudulent financial reporting.

4. Difficulties with cash flow management: Accrual basis accounting may not provide an
accurate picture of a company's cash flow, which can make cash flow management
more difficult.

In summary, accrual basis accounting provides a more accurate and complete picture of
a company's financial performance and position, which can improve decision-making
and compliance with legal and accounting standards. However, it is more complex than
cash basis accounting, may create timing issues, and can be subject to manipulation.

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1.4 Benefits and Limitations of Accounting Concepts

Accounting concepts have several benefits and limitations that businesses and individuals
should be aware of:

Benefits:

1. Provides a standardized framework: Accounting concepts provide a standardized

framework that businesses and individuals can use to understand financial information.

2. Ensures consistency: Accounting concepts help to ensure that financial information is

recorded and reported consistently across time periods and across organizations .

3. Provides reliable information: Accounting concepts ensure that financial information is

reliable and accurate, making it easier for businesses and individuals to make informed
decisions.

4. Helps to identify trends: Accounting concepts allow businesses to identify trends in

financial information, which can be used to make decisions about the future.

5. Facilitates financial planning: Accounting concepts provide the necessary information

for businesses to plan for the future, including budgeting and forecasting.

Limitations:

1. Can be complex: Accounting concepts can be complex and difficult to understand, especially
for those without a background in accounting or finance.

2. Relies on estimates: Accounting concepts often rely on estimates, such as the useful life of an
asset or the expected collectability of accounts receivable, which can be subjective and may not
always be accurate.

3. May not reflect current market values: Accounting concepts often record assets at their
historical cost, rather than their current market value, which may not reflect the true value of
the asset.

4. Does not consider non-financial factors : Accounting concepts do not take into account non-
financial factors, such as customer satisfaction or employee morale, which can also impact the
success of a business.

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5. Can be manipulated: Accounting concepts can be manipulated by businesses to present a

more favorable financial picture, such as through aggressive revenue recognition or by hiding
liabilities off-balance sheet.

1.5 Importance of Accounting Concepts

Accounting concepts are important for several reasons:

1. Standardization: Accounting concepts provide a standardized framework for

recording and reporting financial information. This consistency makes it easier to
compare financial information between different organizations and across different time
periods.

2. Reliable Information: Accounting concepts ensure that financial information is

reliable and accurate. This information can be used by stakeholders, such as investors,
creditors, and management, to make informed decisions about the financial health of a
business.

3. Planning: Accounting concepts provide businesses with the necessary information to

plan for the future, such as budgeting, forecasting, and cash flow management.

4. Decision-making: Accounting concepts provide businesses with the information they

need to make informed decisions about the future. For example, they can use financial
information to decide whether to invest in new equipment, expand operations, or
launch a new product.

5. Compliance: Accounting concepts ensure that businesses comply with financial

reporting requirements, such as the Generally Accepted Accounting Principles (GAAP) or
International Financial Reporting Standards (IFRS).

6. Transparency: Accounting concepts provide transparency into the financial

operations of a business, which can help to build trust and credibility with stakeholders.

7. Accountability: Accounting concepts help to hold businesses accountable for their

financial performance and provide a basis for assessing their success or failure.

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In summary, accounting concepts play a critical role in providing reliable financial information,
facilitating decision-making and ensuring compliance with financial reporting requirements.
They are an essential tool for businesses and stakeholders alike.

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