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ACCT 504 Accounting Certain Concepts Are Perceived DeVry University

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DeVry University

ACCT 504 Accounting Certain Concepts Are Perceived DeVry University

To avoid confusion and to achieve uniformity, accounting process is applied within the conceptual
framework of ‘Generally Accepted Accounting Principles’ (GAAPs). The term GAAPs is used to describe rules
developed for the preparation of the financial statements and are called concepts, conventions, postulates,
principles etc. These GAAPs are the backbone of the accounting information system, without which the
whole system cannot even stand erectly. These principles are the ground rules, which define the parameters
and constraints within which accounting reports are generated. Accounting principles are basic norms and
assumptions on which the whole accounting system has been developed and established. Accountant
also adheres to various accounting standards issued by the regulatory authority for the standardization of
accounting policies to be followed under specific circumstances. These conceptual frameworks, GAAPs and
accounting standards are considered as the theory base of accounting.
Accounting concepts define the assumptions on the basis of which financial statements of a business
entity are prepared. Certain concepts are perceived, assumed and accepted in accounting to provide a
unifying structure and internal logic to accounting process. The word concept means idea or notion, which
has universal application. Financial transactions are interpreted in the light of the concepts, which govern
accounting methods. Concepts are those basic assumptions and conditions, which form the basis upon
which the accountancy has been laid. Unlike physical science, accounting concepts are only result of broad
consensus. These accounting concepts lay the foundation on the basis of which the accounting principles
are formulated.
“Accounting principles are a body of doctrines commonly associated with the theory and procedures of
accounting serving as an explanation of current practices and as a guide for selection of conventions or
procedures where alternatives exist.”
Accounting principles must satisfy the following conditions:
1. They should be based on real assumptions;
2. They must be simple, understandable and explanatory;
3. They must be followed consistently;
4. They should be able to reflect future predictions;
5. They should be informational for the users.
Accounting conventions emerge out of accounting practices, commonly known as accounting principles,
adopted by various organizations over a period of time. These conventions are derived by usage and
practice. The accountancy bodies of the world may change any of the convention to improve the quality of
accounting information. Accounting conventions need not have universal application.
In the study material, the terms ‘accounting concepts’, ‘accounting principles’ and ‘accounting conventions’
have been used interchangeably to mean those basic points of agreement on which financial accounting
theory and practice are founded.
Now we shall study in detail the various accounting concepts on which accounting is based. The following
are the widely accepted accounting concepts:
(a) Entity concept: Entity concept states that business enterprise is a separate identity apart from its owner.
Accountants should treat a business as distinct from its owner. Business transactions are recorded in the
business books of accounts and owner’s transactions in his personal books of accounts. The practice of
distinguishing the affairs of the business from the personal affairs of the owners originated only in the
early days of the double-entry book-keeping. This concept helps in keeping business affairs free from
the influence of the personal affairs of the owner. This basic concept is applied to all the organizations
whether sole proprietorship or partnership or corporate entities.
Entity concept means that the enterprise is liable to the owner for capital investment made by the
owner. Since the owner invested capital, which is also called risk capital, he has claim on the profit
of the enterprise. A portion of profit which is apportioned to the owner and is immediately payable
becomes current liability in the case of corporate entities.
Example: Mr. X started business investing ` 7,00,000 with which he purchased machinery for ` 5,00,000
and maintained the balance in hand. The financial position of the will be as follows:
Capital 7,00,000
Machinery 5,00,000
Cash 2,00,000
This means that the enterprise owes to Mr. X ` 7,00,000. Now if Mr. X spends ` 5,000 to meet his family
expenses from the business fund, then it should not be taken as business expenses and would be
charged to his capital account (i.e., his investment would be reduced by ` 5,000). Following the entity
concept the revised financial position would be
Liability ` `
Capital 7,00,000
Less : Drawings (5,000) 6,95,000
Machinery 5,00,000
Cash 1,95,000
(b) Money measurement concept: As per this concept, only those transactions, which can be measured in
terms of money are recorded. Since money is the medium of exchange and the standard of economic
value, this concept requires that those transactions alone that are capable of being measured in terms
of money be only to be recorded in the books of accounts. Transactions, even if, they affect the results of
the business materially, are not recorded if they are not convertible in monetary terms. Transactions and
events that cannot be expressed in terms of money are not recorded in the business books. For example;
employees of the organization are, no doubt, the assets of the organizations but their measurement in
monetary terms is not possible therefore, not included in the books of account of the organization.
Measuring unit for money is taken as the currency of the ruling country i.e., the ruling currency of a
country provides a common denomination for the value of material objects. The monetary unit though
an inelastic yardstick, remains indispensable tool of accounting.
It may be mentioned that when transactions occur across the boundary of a country, one may see many
currencies. Suppose a businessman sells goods worth ` 50 lakhs at home and he also sells goods worth
of 1 lakh Euro in the United States. What is his total sales? ` 50 lakhs plus 1 lakh Euro.
These are not amenable to even arithmetic treatment. So transactions are to be recorded at uniform
monetary unit i.e. in one currency. Suppose EURO 1 = ` 71.
Total Sales = ` 50 lakhs plus 71 lakhs = ` 121 lakhs. Money Measurement Concept imparts the essential
flexibility for measurement and interpretation of accounting data.
This concept ignores that money is an inelastic yardstick for measurement as it is based on the implicit
assumption that purchasing power of the money is not of sufficient importance as to require adjustment.
Also, many material transactions and events are not recorded in the books of accounts just because
theycannot be measured in monetary terms. Therefore it is recognized by all the accountants that this
concept has its own limitations and inadequacies. Yet it is used for accounting purposes because it is
not possible to adopt a better measurement scale.
Entity and money measurement are viewed as the basic concepts on which other procedural concepts
(c) Periodicity concept: This is also called the concept of definite accounting period. As per ‘going concern’
concept an indefinite life of the entity is assumed. For a business entity it causes inconvenience to
measure performance achieved by the entity in the ordinary course of business.
If a textile mill lasts for 100 years, it is not desirable to measure its performance as well as financial
position only at the end of its life.
So a small but workable fraction of time is chosen out of infinite life cycle of the business entity for
measuring performance and looking at the financial position. Generally one year period is taken up for
performance measurement and appraisal of financial position. However, it may also be 6 months or 9
months or 15 months.
According to this concept accounts should be prepared after every period & not at the end of the life of
the entity. Usually this period is one calendar year. We generally follow from 1st April of a year to 31st
March of the immediately following year.
Thus, for performance appraisal it is not necessary to look into the revenue and expenses of an unduly
long time-frame. This concept makes the accounting system workable and the term ‘accrual’ meaningful.
If one thinks of indefinite time-frame, nothing will accrue. There cannot be unpaid expenses and nonreceipt
of revenue. Accrued expenses or accrued revenue is only with reference to a finite time-frame
which is called accounting period.
Thus, the periodicity concept facilitates in:
(i) Comparing of financial statements of different periods
(ii) Uniform and consistent accounting treatment for ascertaining the profit and assets of the business
(iii) Matching periodic revenues with expenses for getting correct results of the business operations
(d) Accrual concept: Under accrual concept, the effects of transactions and other events are recognised
on mercantile basis i.e., when they occur (and not as cash or a cash equivalent is received or paid) and
they are recorded in the accounting records and reported in the financial statements of the periods
to which they relate. Financial statements prepared on the accrual basis inform users not only of past
events involving the payment and receipt of cash but also of obligations to pay cash in the future and
of resources that represent cash to be received in the future.
To understand accrual assumption knowledge of revenues and expenses is required. Revenue is the
gross inflow of cash, receivables and other consideration arising in the course of the ordinary activities
of an enterprise from sale of goods, from rendering services and from the use by others of enterprise’s
resources yielding interest, royalties and dividends. For example, (1) Mr. X started a cloth merchandising.
He invested ` 50,000, bought merchandise worth ` 50,000. He sold such merchandise for ` 60,000.
Customers paid him ` 50,000 cash and assure him to pay ` 10,000 shortly. His revenue is ` 60,000. It
arose in the ordinary course of cloth business; Mr. X received ` 50,000 in cash and ` 10,000 by way of
Take another example; (2) an electricity supply undertaking supplies electricity spending ` 16,00,000
for fuel and wages and collects electricity bill in one month ` 20,00,000 by way of electricity charges.
This is also revenue which arose from rendering services.
Lastly, (3) Mr. A invested ` 1,00,000 in a business. He purchased a machine paying ` 1,00,000. He hired
it out for ` 20,000 annually to Mr. B. ` 20,000 is the revenue of Mr. A; it arose from the use by others of
the enterprise’s resources.
Expense is a cost relating to the operations of an accounting period or to the revenue earned during the
period or the benefits of which do not extend beyond that period.
In the first example, Mr. X spent ` 50,000 to buy the merchandise; it is the expense of generating revenue
of ` 60,000. In the second instance ` 16,00,000 are the expenses. Also whenever any asset is used it has
a finite life to generate benefit. Suppose, the machine purchased by Mr. A in the third example will last
for 10 years only. Then ` 10,000 is the expense every year relating to the cost of machinery. For the time
being, ignore the idea of accounting period.
Accrual means recognition of revenue and costs as they are earned or incurred and not as money is
received or paid. The accrual concept relates to measurement of income, identifying assets and liabilities.
Example: Mr. J D buys clothing of ` 50,000 paying cash ` 20,000 and sells at ` 60,000 of which customers
paid only ` 50,000.
His revenue is ` 60,000, not ` 50,000 cash received. Expense (i.e., cost incurred for the revenue) is
`50,000, not ` 20,000 cash paid. So the accrual concept based profit is ` 10,000 (Revenue – Expenses).
As per Accrual Concept : Revenue – Expenses = Profit
Accrual Concept provides the foundation on which the structure of present day accounting has been
Alternative as per Cash basis
Cash received in ordinary course of business – Cash paid in ordinary course of business = profit.
Revenue may not be realised in cash. Cash may be received simultaneously or
(i) before revenue is created (A. 1)
(ii) after revenue is created (A. 2)
Expenses may not be paid in cash. Cash may be paid simultaneously or
(i) before expense is made (B. 1) (ii) after expense is made (B. 2)
A. 1 creates a liability when cash is received in advance. A. 2 creates an asset called Trade receivables.
B.1 creates an asset called Trade Advance when cash is paid in advance while B. 2 creates a liability
called payables or Trade payables or outstanding liabilities. If the expenses remain unpaid in respect of
goods, it is called Trade payables, if it remains unpaid for other expenses, it is called Expense payables.
(e) Matching concept: In this concept, all expenses matched with the revenue of that period should only
be taken into consideration. In the financial statements of the organization if any revenue is recognized
then expenses related to earn that revenue should also be recognized.
This concept is based on accrual concept as it considers the occurrence of expenses and income and
do not concentrate on actual inflow or outflow of cash. This leads to adjustment of certain items like
prepaid and outstanding expenses, unearned or accrued incomes.
It is not necessary that every expense identify every income. Some expenses are directly related to the
revenue and some are time bound. For example:- selling expenses are directly related to sales but rent,
salaries etc are recorded on accrual basis for a particular accounting period. In other words periodicity
concept has also been followed while applying matching concept.
Mr. P K started cloth business. He purchased 10,000 pcs. garments @ ` 100 per piece and sold 8,000 pcs.
@ ` 150 per piece during the accounting period of 12 months 1st January to 31st December, 2015. He
paid shop rent @ ` 3,000 per month for 11 months and paid ` 8,00,000 to the suppliers of garments and
received ` 10,00,000 from the customers.


ACCT 504 Accounting Certain Concepts Are Perceived DeVry University

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