How to explain the important Concept of Accounting? Image credit from #Pixabay.
Accounting is the systematic recordation of the financial transactions of a business. Accounting principles are built on a foundation of a few basic concepts. The meaning of accounting can be erroneously expanded to include internal and external auditing. Internal auditing involves the testing of systems to see if they operate as intended, and so falls outside of the traditional definition of accounting. External auditing involves the examination of accounting records to see if the auditor can attest to the fairness of the information presented in the financial statements; again, this task falls outside of the traditional definition of accounting. So, what is the question we going to study; How to explain the important Concept of Accounting?
These concepts are so basic that most preparers of financial statements do not consciously think of them. As stated earlier, they are regarded as self-evident. Some accounting researchers and theorists argue that certain of the present accounting concepts are wrong and should be changed. Nevertheless, in order to understand accounting as it now exists, one must understand the underlying concepts currently used. Basic accounting concepts discussed herein may not be identical to those listed by other authors or groups. However, these are the concepts that are widely accepted and used in practice by preparers of financial statements and by auditors while verifying such statements.
The important accounting concepts are as follows:
According to the Financial Accounting Standards Board (US):
“Accrual accounting attempts to record the financial effects on an enterprise of transactions and other events and circumstances that have cash consequences for the enterprise in the periods in which those transactions, events, and circumstances occur rather than only in the periods in which cash is received or paid by the enterprise. Accrual accounting is concerned with the process by which cash expended on resources and activities is returned as more (or perhaps less) cash to the enterprise, not just with the beginning and end of that process. It recognizes that the buying, producing, selling and other operations of an enterprise during a period, as well as other events that affect enterprise performance often do not coincide with the cash receipts and payments of the periods.”
Realization concept and matching concept are central to accrual accounting. Accrual accounting measures income for a period as the difference between the revenues recognized in that period and the expenses that are matched with those revenues. Under accrual accounting, the period’s revenues generally are not the same as the period’s cash receipts from customers, and the period’s expenses generally are not the same as the period’s cash disbursements.
Under cash-basis accounting, sales are not recorded until the period in which they are received in cash. Similarly, costs are deducted from sales in the period in which they are paid for cash disbursements. Thus, neither the realization nor matching concept applies in cash-basis accounting. In practice, “pure” cash-basis accounting is rare. This is because a pure cash-basis approach would require treating the acquisition of inventories as a reduction in profit when the acquisition costs are paid rather than when the inventories are sold.
Similarly, costs of acquiring items of plant and equipment would be treated as profit reductions when paid in cash rather than in the later periods when these long-lived items are used. Clearly, such a pure cash-basis approach would result in balance sheets and income statements that would be of limited usefulness. Thus, what is commonly called cash-basis accounting is actually a mixture of a cash basis for some items (especially sales and period costs) and accrual basis for other items (especially product costs and long-lived assets).
This mixture is also sometimes called modified cash-basis accounting to distinguish it from a pure cash-basis method. Cash-basis accounting is seen most often in small firms that provide services and therefore do not have significant amounts of inventories. Examples include restaurants, beauty parlors, and barber shops, and income tax preparation firms. Since most of these establishments do not extend credit to their customers, cash-basis profit may not differ dramatically from accrual-basis income. Nevertheless, cash-basis accounting is not permitted by GAAP for any type of business entity.
This principle is often described as “anticipate no profit, and provide for all possible losses.” This characterization might be viewed as the reactive version of the mini-max managerial philosophy, i.e., minimize the chance of maximum losses. The concept of accounting conservatism suggests that when and where uncertainty and risk exposure so warrant, accounting takes a wary and watchful stance until the appearance of evidence to the contrary. Accounting conservatism does not mean intentionally understating income and assets; it applies only to situations in which there are reasonable doubts.
For example, inventories are valued at the lower ends of the cost or market value. In its application to the income statement, conservatism encourages the recognition of all losses that have occurred or are likely to occur but does not acknowledge gains until actually realized. The early amortization of intangible assets and the restrictions against recording appreciation of assets have also, at least to some extent, been motivated by conservatism. Failure to recognize revenue until a sale has taken place is still another manifestation of conservatism.
The matching concept in financial accounting is the process of matching (relating) accomplishments or revenues (as measured by the selling prices of goods and services delivered) with efforts or expenses (as measured by the cost of goods and services used) to a particular period for which the income is being determined. This concept emphasizes which items of cost are expenses in a given accounting period. That is, costs are reported as expenses in the accounting period in which the revenue associated with those costs is reported.
For example, when the sales value of some goods is reported as revenue in a year, the cost of those goods would be reported as expenses in the same year. Matching concepts need to be fulfilled only after realization concept has been completed by the accountant: first revenues are measured in accordance with the realization concept and then costs are associated with these revenues. Costs are matched with revenues, not the other way around. The matching process, therefore, requires cost allocation which is significant in historical cost accounting.
Past (historical) costs are examined and are subjected to a procedure whereby elements of cost regarded as having expired service potential are allocated or matched against relevant revenues. The remaining elements of costs which are regarded as continuing to have future service potential are carried forward in the historical balance sheet and are termed as assets. Thus, the balance sheet is nothing more than a report of unallocated past costs waiting for the expiry of their estimated future service potential before being matched with suitable revenues.
The realization or recognition concept indicates the amount of revenue that should be recognized from a given sale. Realization rules help the accountant in determining that a revenue or expense has occurred so that it can be measured, recorded, and reported in financial reports. Realization refers to inflows of cash or claims to cash (e.g., accounts, receivable) arising from the sale of goods or services.
Thus, if a customer buys Rs. 500 worth of items at a grocery store, paying cash, the store realizes Rs. 500 from the sale. If a clothing store sells a suit for Rs. 3,000, the purchaser agreeing to pay within 30 days, the store realizes Rs. 3,000 (in receivables) from the sale, provided that the purchaser has a good credit record so that payment is reasonably certain (conservatism concept). The realization concept states that the amount recognized as revenue is the amount that is reasonably certain to be realized—that is, that customers are reasonably certain to pay.
Of course, there is room for differences in judgment as to how certain “reasonably certain” are. However, the concept does clearly allow for the amount of revenue recognized to be less than the selling price of the goods and services sold. The obvious situation is the sale of merchandise at a discount—at an amount less than its normal selling price. In such cases, revenue is recorded at the lower amount, not the normal price.
This concept requires that once an organization has decided on one method, it should use the same method for all subsequent transactions and events of the same nature unless it has sound reasons to change methods. If accounting methods are frequently changed, comparison of financial statements for one period with those of another period would be difficult. The consistent use of accounting methods and procedures over time will check the distortion of profit and loss account and the balance sheet and the possible manipulation of these statements. Consistency is necessary to help external users in comparing financial statements of a given firm over time and in making sound economic decisions.
In law, there is a doctrine called de minimis noncurative lex, which means that the court will not consider trivial matters. Similarly, the accountant does not attempt to record events so insignificant that the work of recording them is not justified by the usefulness of the results. Materiality concept implies that the transactions and events that have immaterial or insignificant effects should not be recorded and reported in the financial statements. It is argued that the recording of insignificant events cannot be justified in terms of its subsequent poor utility to users.
For example, conceptually, a brand-new pad of paper is an asset of the entity. Every time someone writes on a page of the pad, part of this asset is used up, and retained earnings decrease correspondingly. Theoretically, it would be possible to ascertain the number of parts used pads that are owned by the entity at the end of the accounting period and to show this amount as an asset. But the cost of such an effort would obviously be unwarranted, and no accountant would attempt to do this.
Accountants take the simpler, even though less exact, course of action and treat the asset as being used up (expensed) either at the time the pads were purchased or at the time they were issued from supplies inventory to the user. Unfortunately, there is no agreement on the meaning of materiality and the exact line separating material events from immaterial events.
The decision depends on judgment and common sense. It is for the preparer of accounts to interpret what is and what is not material. Probably the materiality of an event or transaction can be decided in terms of its impact on the financial position, results of operations, changes in the financial position of an organization and on evaluation or decisions made by users.
The full disclosure concept requires that a business enterprise should provide all relevant information to external users for the purpose of sound economic decisions. This concept implies that no information of substance or of interest to the average investors will be omitted or concealed from an entity’s financial statements.
The entity concept assumes that the financial statements and other accounting information are for the specific business enterprise which is distinct from its owners. Consequently, the analysis of business transactions involving costs and revenue is expressed in terms of the changes in the firm’s financial conditions. Similarly, the assets and liabilities devoted to business activities are entity assets and liabilities.
The transactions of the enterprise are to be reported rather than the transaction of the enterprise’s owners. This concept, therefore, enables the accountant to distinguish between personal and business transactions. The concept applies to the sole proprietorship, partnership, companies, and small and large enterprise. It may also apply to a segment of a firm, such as division, or several firms, such as when inter-related firms are consolidated.
A business entity is viewed as continuing in operation in the absence of evidence to the contrary. Because of the relative permanence of enterprises, financial accounting is formulated assuming that the business will continue to operate for an indefinitely long period in the future. The going-concern concept justifies the valuation of assets on a non-liquidation basis and it calls for the use of historical cost for many valuations.
Also, the fixed assets and intangibles are amortized over their useful life rather than over a shorter period in expectation of early liquidation. The going-concern concept leads to the proposition that individual financial statements are part of a continuous, inter-related series of statements. This further implies that data communicated are tentative and that current statements should disclose adjustments to past year statements revealed by more recent developments.
A unit of exchange and measurement is necessary to account for the transactions of business enterprises in a uniform manner. The common denominator chosen in accounting is the monetary unit. Money is the common denominator in terms of which the exchangeability of goods and services, including labor, natural resources, and capital, are measured. Money measurement concept holds that accounting is a measurement and communication process of the activities of the firm that are measurable in monetary terms. Obviously, financial statements should indicate the money used. Money measurement concept implies two limitations of accounting.
First, accounting is limited to the production of information expressed in terms of a monetary unit: it does not record and communicate other relevant but non-monetary information. Secondly, the monetary measurement concept concerns the limitations of the monetary unit itself as a unit of measure. The primary characteristics of the monetary unit—purchasing power, or the number of goods or services that money can acquire—is of concern. Traditionally, financial accounting has dealt with this problem by stating that this concept assumes either that the purchasing power of the monetary unit is stable over time or that the changes in prices are not significant. While still accepted for current financial reporting, the stable monetary unit concept is the object of continuous and persistent criticism.
Financial accounting provides information about the economic activities of an enterprise for specified time periods that are shorter than the life of the enterprise. Normally, the time periods are of equal length to facilitate comparison. The time period is identified in the financial statements.
The time periods are usually of twelve months. Sometimes quarterly or half-yearly statements are also issued. These are considered interim and different from annual statements. For managerial use, statements covering shorter periods such as a month or a week may also be prepared.
The cost concept requires that assets be recorded at the exchange price, i.e., acquisition cost or historical cost. Historical cost is recognized as the appropriate valuation basis for recognition of the acquisition of all goods and services, expenses, costs, and equities. For accounting purposes, business transactions are normally measured in terms of the actual prices or costs at the time the transaction occurs, i.e., financial accounting measurements are primarily based on exchange prices at which economic resources and obligations are exchanged.
Thus, the amounts at which assets are listed in the accounts of a firm do not indicate what the assets could be sold for. The historical cost concept implies that since the business is not going to sell its asset as such there is little point in revaluing assets to reflect current values. In addition, for practical reasons, the accountant prefers the reporting of actual costs to market values which are difficult to verify.
This concept lies at the heart of the whole accounting process. The accountant records events affecting the wealth of a particular entity. The question is—which aspect of this wealth is important? Since an accounting entity is an artificial creation, it is essential to know to whom its resources belong to or what purpose they serve. It is also important to know what kind of resources it controls, e.g., cash, buildings or land.
Accounts recording systems have therefore developed so as to show two main things: (a) the source of wealth, and (b) the form it takes. Suppose Mr. X decides to establish a business and transfers Rs. 1, 00,000 from his private bank account to a separate business account.
He might record this event as follows:
Clearly, the source of wealth must be numerically equal to the form of wealth. Since they are simply different aspects of the same thing, i.e., in the form of an equation: S (sources) must equal F (forms). Moreover, any transaction or event affecting the wealth of entity must have two aspects recorded in order to maintain the equality of both sides of the accounting equation.
If the business has acquired an asset, it must have resulted in one of the following:
This does not mean that a transaction will affect both the source and form of wealth.
There are four categories of events affecting the accounting equation:
The example given above illustrates category (a) since the commencing transaction for the entity results in the source of wealth, and form of wealth, cash, both increasing from zero to Rs. 1,00,000. By contrast, X might decide to withdraw Rs. 20,000 cash from the business.
It is essential to appreciate why both sides of the equation decrease. By taking out cash, X automatically reduces his supply of private finance to the business by the same amount. Suppose now that Mr. X buys stocks of goods for Rs. 30,000 with the available cash. His supply of capital does not change, but the composition of the business assets does.
The two aspects of this transaction are not in the same direction but compensatory, an increase in stocks of setting a decrease in cash. Similarly, sources of wealth also may be affected by a transaction. Thus, if X gives his son Y, an Rs. 20,000 share in the business by transferring part of his own interest, the effect is as follows: If, however, X gives Y; Rs. 20,000 in cash privately and Y then puts it into the business, both sides of the equation would be affected. Y’s capital of Rs. 20,000 being balanced by an extra Rs. 20,000 in cash, X’s capital remaining at Rs. 80,000.
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