1. Accounting Concepts

Accounting concepts define the assumptions on which the financial statements of a business are prepared. These concepts are perceived, assumed, and accepted in accounting to provide a unifying structure and internal logic to the accounting process.

The word concept means idea or notion with universal application. Financial transactions are interpreted in light of these governing concepts.

2. Accounting Principles

Accounting principles must satisfy the following conditions:

• Based on real assumptions
• Simple, understandable, and explanatory
• Consistently followed
• Able to reflect future predictions
• Informative for users

3. Accounting Conventions

Accounting conventions arise from commonly accepted accounting practices over time. These are developed through usage and are subject to change by professional accountancy bodies worldwide.

4. Concepts, Principles, and Conventions — An Overview

Below are the widely accepted accounting concepts:

a) Entity Concept

Entity concept states that a 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 the owner's transactions in his personal books of accounts. 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 the 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.

b) Money Measurement Concept

Only those transactions measurable in monetary terms are recorded in the books of accounts.

c) Periodicity Concept

Also known as the Definite Accounting Period concept. This allows:

• Comparison of financial statements over different periods
• Consistent treatment of profit and asset recognition
• Proper matching of periodic revenue and expenses

d) Accrual Concept

Revenues and expenses are recorded when they occur, not when cash is received or paid. This aligns financial results with relevant periods.

e) Matching Concept

Expenses must match the revenues of the same period. For example, sales commissions are directly related to sales, while rent and salaries are time-based and recorded on an accrual basis.

This concept supports accrual and periodicity assumptions.

 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 an accrual basis for a particular accounting period. In other words periodicity concept has also been followed while applying the matching concept.

f) Going Concern Concept

The financial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed. The valuation of assets of a business entity is dependent on this assumption. Traditionally, accountants follow historical costs in the majority of cases.

g) Cost Concept

Assets are recorded at their original purchase cost, ensuring objectivity and reliability in valuations. Market values or future values are not recorded unless realized.

h) Realisation Concept

A gain or loss is recognized only when it is realized. Even if an asset increases in market value, it is not recorded until the increase is actually realized.

i) Dual Aspect Concept

The foundation of double-entry bookkeeping: every transaction affects two accounts. Examples:

• Increase in one asset, decrease in another
• Increase in asset and increase in liability
• Decrease in liability and decrease in asset

j) Conservatism

Do not anticipate income but provide for all possible losses. For instance, inventory is valued at cost or market price, whichever is lower.

Key characteristics include:

• Prudence: Guard against probable losses
• Neutrality: Avoid bias
• Faithful representation: Report values fairly

k) Consistency

Accounting policies should remain consistent over time to ensure comparability. Changes are acceptable only in these cases:

• To comply with Accounting Standards
• Legal compliance
• Reflecting a truer and fairer picture

l) Materiality

Insignificant information can be ignored if it doesn’t affect decision-making. Only material items are included in financial statements to maintain relevance and efficiency.

5. Fundamental Accounting Assumptions

There are three fundamental accounting assumptions:

• Going Concern
• Consistency
• Accrual

These three are the pillars of all financial reporting systems.

If nothing has been written about the fundamental accounting assumption in the financial statements then it is assumed that they have already been followed in their preparation of financial statements. However, if any of the above mentioned fundamental accounting assumptions is not followed then this fact should be specifically disclosed.

5.1 Qualitative Characteristics of Financial Statements

These attributes make financial information useful to users:

1. Understandability

Information must be easy to understand by users who have reasonable knowledge of business and accounting.

2. Relevance

Data must be useful in decision-making. It helps users evaluate past, present, or future events.

3. Reliability

Reliable information is free from material error and bias and faithfully represents actual events.

4. Comparability

Users should be able to compare financial statements across periods and between enterprises. This ensures informed decision-making.

5. Materiality

Only items that significantly influence user decisions are considered material.

6. Faithful Representation

Data should truthfully represent all transactions and events that it is meant to reflect.

7. Substance Over Form

Transactions should be recorded based on their economic substance, not just their legal form.

8. Neutrality

Information must be unbiased and not influence decisions to achieve a predetermined outcome.

9. Prudence

Accountants must consider uncertainties and recognize losses when probable, but avoid recognizing unrealized gains.

10. Full, Fair, and Adequate Disclosure

All relevant information must be disclosed to internal and external users, providing a complete view of the financial health of the business. Financial statements must comply with Generally Accepted Accounting Principles (GAAP).

👉 Related Reading:

Understanding the Basics of Accounting: From Book-Keeping to Decision-Making

SELF EXAMINATION QUESTIONS

Pick up the correct answer from the given choices:

(1) (i) All the following items are classified as fundamental accounting assumptions except

• Consistency
• Business entity.
• Going concern. 
• Accrual.

(ii) Two primary qualitative characteristics of financial statements are

• Understandability and materiality.
• Relevance and reliability.
• Relevance and understandability.
• Materiality and reliability

(iii) Kanika Enterprises follows the written down value method of depreciating machinery year after year due to

• Comparability
• Consistency.
• Convenience.
• All of the above.

(iv) A purchased a car for 5,00,000, making a down payment of 1,00,000 and signing a 4,00,000 bill payable due in 60 days. As a result of this transaction

• Total assets increased by 5,00,000.
• Total liabilities increased by 4,00,000.
• Total assets increased by 4,00,000.
• Total assets increased by 4,00,000 with corresponding increase in liabilities by 4,00,000.

(v) Mohan purchased goods for 15,00,000 and sold 4/5th of the goods amounting 18,00,00 and met expenses amounting 2,50,000 during the year, 2011. He counted net profit as 3,50,000. Which accounting concept was followed by him?

• Entity.
• Periodicity.
• Matching.
• Conservatism.

(vi) A businessman purchased goods for 25,00,000 and sold 80% of such goods during the accounting year ended 31st March, 2011. The market value of the remaining goods was 4,00,000. He valued the closing stock at cost. He violated the concept of

• Money measurement.
• Conservatism.
• Cost.
• Periodicity.

(vii) Capital brought in by the proprietor is an example of

• Increase in assets and increase in liability.
• Increase in liability and decrease in assets.
• Increase in assets and decrease in liability.
• Increase in one asset and decrease in another asset.

[Ans. i. (b), ii. (b), iii. (c), iv. (d), v. (c), vi. (b),  vii. (a).]

2. (i) Assets are held in the business for the purpose of 

• Resale.
• Conversion into cash.
• Earning revenue.
• None of the above.

(ii) Revenue from sale of products, is generally, realized in the period in

• Cash is collected.
• Sale is made.
• Products are manufactured.
• None of the above.

(iii) The concept of conservatism when applied to the balance sheet results in

• Understatement of assets.
• Overstatement of assets.
• Overstatement of capital.
• None of the above.

(iv) Decrease in the amount of creditors results in

• Increase in cash.
• Decrease in cash.
• Decrease in assets.
• No change in assets.

(v) The determination of expenses for an accounting period is based on the principle of

• Objectivity.
• Materiality.
• Matching.
• Periodicity.

(vi) Economic life of an enterprise is split into the periodic interval as per

• Entity.
• Matching.
• Going concern.
• Accrual.

[Ans. i. (c), ii. (b), iii. (a), iv. (b), v. (c), vi. (c).

(3) (i) If an individual asset is increased, there will be a corresponding

• Increase of another asset or increase of capital.
• Decrease of another asset or increase of liability.
• Decrease of specific liability or decrease of capital.
• Increase in drawings and liability.

(ii) Purchase of machinery for cash

• Decreases total assets.
• Increases total assets.
• Retains total assets unchanged.
• Decreases total liabilities.

(iii.) Consider the following data pertaining to Alpha Ltd.:

While finalizing the annual accounts, if the company values the machinery at 12,00,000. Which of the following concepts is violated by the Alpha Ltd?

• Cost
• Matching
• Accrual
• Periodicity

[Ans. 3. (i) (b), (ii) (c), (iii) (a)]

(4) A proprietor, Mr. A has reported a profit of 1,25,000 at the end of the financial year after taking into consideration the following amount:

• The cost of an asset of 25,000 has been taken as an expense.
• Mr. A is anticipating a profit of 10,000 on the future sale of a car shown as an asset in his books.
• Salary of 7,000 payable in the financial year has not been taken into account.
• Mr. A purchased an asset for 75,000 but its fair value on the date of purchase was 85,000. Mr. A recorded the value of assets in his books by 85,000.

On the basis of the above facts answer the following questions from the given choices:

(i) What is the correct amount of profit to be reported in the books?

• 1,25,000
• 1,35,000
• 1,50,000
• 1,33,000

(ii). Which measurement base should be followed in the statement (iv)?

• Historical cost
• Current cost
• Replacement cost
• Present value

(iii). Which concept should be followed in the statement (ii)?

• Conservation
• Materiality
• Historical cost
• Accrual

(iv) Which concept should be followed in the statement (iii)?

• Materiality
• Historical cost
• current cost
• Accrual

[Ans. (i)-(d), (ii)-(a), (iii)-(a), (iv)-(d),]