THE CONCEPT OF ACCOUNTING

These basic accounting concepts are as follows: Accruals concept. Revenues are recognized
when earned, and expenses are recognized when assets are consumed. ... Economic
entity concept. The transactions of a business are to be kept separate from those of its owners.

THE PURPOSE OF ACCOUNTING

The purpose of accounting. The purpose of accounting is to accumulate and report on
financial information about the performance, financial position, and cash flows of a business. This
information is then used to reach decisions about how to manage the business, or invest in it, or
lend money to it.

THE PRINCIPLES OF ACCOUNTS

These principles, which serve as the rules for accounting for financial transactions and
preparing financial statements, are known as the “Generally Accepted Accounting Principles,” or
GAAP. The application of the principles by accountants ensures that financial statements are
both informative and reliable.

Accounting not only records financial transactions and conveys the

financial position of a business enterprise; it also analyses and reports the
information in documents called “financial statements.”
Recording every financial transaction is important to a business
organisation and its creditors and investors. Accounting uses a formalised
and regulated system that follows standardised principles and procedures.
The job of accounting is done by professionals who have educational
degrees acquired after years of study. While a small business may have an
accountant or a bookkeeper to record money transactions, a large
corporation has an accounts department, which supplies information to:
 Managers who guide the company.
 Investors who want to know how the business is doing.
 Analysts and brokerage firms dealing with the company’s stock.
 The government, which decides how much tax should be collected from
the company.
Accounting Principles
Obviously, if each business organisation conveys its information in its own
way, we will have a babel of unusable financial data.
Personal systems of accounting may have worked in the days when most
companies were owned by sole proprietors or partners, but they do not
anymore, in this era of joint stock companies.
These companies have thousands of stakeholders who have invested
millions, and they need a uniform, standardised system of accounting by
which companies can be compared on the basis of their performance and
value.
Therefore, accounting principles based on certain concepts, convention,
and tradition have been evolved by accounting authorities and regulators
and are followed internationally.
These principles, which serve as the rules for accounting for financial
transactions and preparing financial statements, are known as the
“Generally Accepted Accounting Principles,” or GAAP.
The application of the principles by accountants ensures that financial
statements are both informative and reliable.
It ensures that common practices and conventions are followed, and that
the common rules and procedures are complied with. This observance of
accounting principles has helped developed a widely understood grammar
and vocabulary for recording financial statements.
However, it should be said that just as there may be variations in the usage
of a language by two people living in two continents, there may be minor
differences in the application of accounting rules and procedures
depending on the accountant.
For example, two accountants may choose two equally correct methods for
recording a particular transaction based on their own professional
judgement and knowledge.
Accounting principles are accepted as such if they are (1) objective; (2)
usable in practical situations; (3) reliable; (4) feasible (they can be applied
without incurring high costs); and (5) comprehensible to those with a basic
knowledge of finance.
Accounting principles involve both accounting concepts and accounting
conventions. Here are brief explanations.
Accounting Concepts
1. Business entity concept: A business and its owner should be treated
separately as far as their financial transactions are concerned.
2. Money measurement concept: Only business transactions that can be
expressed in terms of money are recorded in accounting, though records
of other types of transactions may be kept separately.
3. Dual aspect concept: For every credit, a corresponding debit is made.
The recording of a transaction is complete only with this dual aspect.
4. Going concern concept: In accounting, a business is expected to continue
for a fairly long time and carry out its commitments and obligations. This
assumes that the business will not be forced to stop functioning and
liquidate its assets at “fire-sale” prices.
5. Cost concept: The fixed assets of a business are recorded on the basis of
their original cost in the first year of accounting. Subsequently, these
assets are recorded minus depreciation. No rise or fall in market price is
taken into account. The concept applies only to fixed assets.
6. Accounting year concept:Each business chooses a specific time period to
complete a cycle of the accounting process—for example, monthly,
quarterly, or annually—as per a fiscal or a calendar year.
7. Matching concept: This principle dictates that for every entry of revenue
recorded in a given accounting period, an equal expense entry has to be
recorded for correctly calculating profit or loss in a given period.
8. Realisation concept:According to this concept, profit is recognised only
when it is earned. An advance or fee paid is not considered a profit until
the goods or services have been delivered to the buyer.

Accounting Conventions
There are four main conventions in practice in accounting: conservatism;
consistency; full disclosure; and materiality.

Conservatism is the convention by which, when two values of a transaction

are available, the lower-value transaction is recorded. By this convention,
profit should never be overestimated, and there should always be a
provision for losses.
Consistency prescribes the use of the same accounting principles from one
period of an accounting cycle to the next, so that the same standards are
applied to calculate profit and loss.
Materiality means that all material facts should be recorded in accounting.
Accountants should record important data and leave out insignificant
information.
Full disclosure entails the revelation of all information, both favourable
and detrimental to a business enterprise, and which are of material value to
creditors and debtors.

Basic Accounting Terms

Here is a quick look at some important accounting terms.
Accounting equation: The accounting equation, the basis for the double-
entry system (see below), is written as follows:
Assets = Liabilities + Stakeholders’ equity
This means that all the assets owned by a company have been financed
from loans from creditors and from equity from investors. “Assets” here
stands for cash, account receivables, inventory, etc., that a company
possesses.
Accounting methods:Companies choose between two methods—cash
accounting or accrual accounting. Under cash basis accounting, preferred
by small businesses, all revenues and expenditures at the time when
payments are actually received or sent are recorded. Under accrual basis
accounting, income is recorded when earned and expenses are recorded
when incurred.
Account receivable: The sum of money owed by your customers after
goods or services have been delivered and/or used.
Account payable: The amount of money you owe creditors, suppliers, etc.,
in return for goods and/or services they have delivered.
Accrual accounting: See “accounting methods.”
Assets (fixed and current): Current assets are assets that will be used
within one year.
For example, cash, inventory, and accounts receivable (see above). Fixed
assets (non-current) may provide benefits to a company for more than one
year—for example, land and machinery.

Balance sheet: A financial report that provides a gist of a company’s assets

and liabilities and owner’s equity at a given time.
Capital: A financial asset and its value, such as cash and goods. Working
capital is current assets minus current liabilities.
Cash accounting: See “accounting methods.”
Cash flow statement: The cash flow statement of a business shows the
balance between the amount of cash earned and the cash expenditure
incurred.
Credit and debit: A credit is an accounting entry that either increases a
liability or equity account, or decreases an asset or expense account. It is
entered on the right in an accounting entry. A debit is an accounting entry
that either increases an asset or expense account, or decreases a liability or
equity account. It is entered on the left in an accounting entry.
Double-entry bookkeeping:Under double-entry bookkeeping, every
transaction is recorded in at least two accounts—as a credit in one account
and as a debit in another.
For example, an automobile repair shop that collects Rs. 10,000 in cash
from a customer enters this amount in the revenue credit side and also in
the cash debit side. If the customer had been given credit, “account
receivable” (see above) would have been used instead of “cash.” (Also see
“single-entry bookkeeping,” below.)

Financial statement: A financial statement is a document that reveals the

financial transactions of a business or a person. The three most important
financial statements for businesses are the balance sheet, cash flow
statement, and profit and loss statement (all three listed here
alphabetically).
General ledger: A complete record of financial transactions over the life of
a company.
Journal entry: An entry in the journal that records financial transactions in
the chronological order.
Profit and loss statement (income statement): A financial statement that
summarises a company’s performance by reviewing revenues, costs and
expenses during a specific period.
Single-entry bookkeeping -Under the single-entry bookkeeping, mainly
used by small or businesses, incomes and expenses are recorded through
daily and monthly summaries of cash receipts and disbursements. (Also see
“double-entry bookkeeping,” above.)
Types of accounting: Financial accounting reports information about a
company’s performance to investors and credits. Management accounting
provides financial data to managers for business development.