1.3 BASIC ACCOUNTING CONCEPTS
Accounting is a system evolved to achieve a set of objectives as outlined earlier (refer to
1.2.1). In order to achieve these objectives we maintain systematic record of all business
transactions and prepare annual reports for the interested parties. Any activity that you
perform is facilitated if you have a set of rules to guide you. When you are driving your
vehicle you keep to the left. You are in fact following a traffic rule. If drivers do not follow
this rule, there will be a chaos on the road. The same thing is true of accounting which has
evolved over a period of several centuries. During this period, certain rules and conventions
have been adopted which serve as guidelines in identifying the events and transactions to be
accounted for, measuring them, recording them in books of account, summarising them, and
reporting them to the interested parties. These rules and conventions are termed as
'Generally Accepted Accounting Principles'. To explain these principles, the writers have
used a variety of terms such as concepts, postulates, conventions, underlying principles,
basic assumptions, etc. The same kule may be described by one author as a concept, by
another as a postulate and still by another as a convention. This often confuses the learners.
Hence, it is better to call all rules and conventions which guide accounting activity and
practice as 'Basic kccounting ~onc'e~ts' These are the fundamental ideas or basic
assumptions underlying tile theory and practice of financial accounting and are the broad
working rules for all accounting activities developed and accepted by the accounting
profession. This brings about uniformity in the practice of accounting.
These concepts can be classified into two broad groups as follows :
i) concepts to be observed at the recording stage i.e., while recording the transactions, and
ii) concepts to be observed at the reporting stage i.e., at the time of preparing the final
accounts.
It must however be remembered that some of them are overlapping and even contradictory.
1.3.1 Concepts to be observed at the recording stage
The concepts which guide us in identifying, measuring and recording the transactions are :
1 Business Entity Concept
2 Money Measurement Concept
3 Objcctive Evidence Concept
4 Historical Record Concept
5 Cost Concept
6 Dual Aspect Concept
Let us take them one by one and learn the accounting implications of each concept.
Business Entity Concept: Business entity means a unit of organised business ar?irity. In
that sense, a provision store, a cloth dealer, an industrial establishment, an electricity supply
undertaking, a bank, a school, a hospital, etc. are all business entities.
From the accounting point of view every business enterprise is an entity separate and
distinct from its pro~rietor(s)/owner(s). The accounting system gives information only about
the business and not its owner@). In other words, we record those transactions in the books of account which relate only to the business. The o\vncr's personal affairs (his expenditure
on housing, food, clothing, etc.) will not appear in the books of accounr of his business.
However, when pcrsonal expenditure of tlie owner is met from business funds it shall also
he recorded in the business books. It will be recorded as drawings by the proprietor and not
as business expenditure.
Another implication of business entity concept is that the owner of a business is to be
treated as a creditor who also has a claim over the assets of the business. As such, the
amotint invested by him (capital) is regarded as a liability for the business.
The business entity concept is applicable to all fosms of business organisations. This
distinction can be easily maintained in the case of a limited company because the company
has a legal entity of its own. But such distinction becomes difficult in case of a sole
proprietorship or partnership, because in the eyes of the law the partner or the sole
proprietor are not considered separate entities. 'They itse persorlally liable for all business
transactions. Eut for accounting purposes, they are to be treated :is separate entities. This
enables lhem to ascertain the profit or loss of business more conveniently and accurately.
Money Meask~rcnlent Concept: Usually, business deals in a variety of items having
different pl~ysical units such as kilograms, quintals, tons, metres, likes, etc. If the sales and
purchases of different items are recorded is tenns of their physical units, adding them
together will pose problotns. But, if these are recordsd in a connnon denomination, their
total becomes homogeneous and ~neaningful. Therefore, we need u common unit of
measurement. Money does this firnction. It is adopted as the common measuring unit for the
purpose of accounting. A11 recording, therefore, is done in terms of the standard cusrency of
the country where business is set up. For example, in India it is done in terms,of Rupees, in
USA it is clone in tenns of US DoIlars, artd so on.
Another implication of rnoney measurement concept is that only those transactioris and
events are to be recorded in the books of account which can be expressed in terms of money
such as purchases, sales, payment of salaries, goods lost in accident, etc. Other happenings
(non-monetaryj like death of an efficient manages or the appointment of an accountant,
howsoever important they may be, are not recorded in the books of account. This is because
their effect is not measurable or cluantifial~le in terms of money.
This approach has its own drawbacks. The value of money changes over a period of time.
The value of rupee today is much less than what it was in 1961. Such a change is nowhere
reflected in accounts. That is why the accou~~ting data does not reflect the true and fair view
of the affairs of the bushzss.
~ence, now-a-days, it is co~lsidered desirable to provide additional data showing the effect
of changes in the price level on the reported income and the assets and. liabilities of the
business.
Objective Evidence Concept: The tek objeclivity refers to being free from bias or free
from subjectivity. Accounting measurements are to be unbiased and verifiable
independently. For this purpose, all accounting transactions should be evidenced and
supported by documents such as itlvoices, receipts, cash memos, etc. These supporting
documents (vouchers) form the basis for making entries in [he books of account and for
their verification by auditors afterwards. AS for the items like depreciation and the provision
for doubtful debts where no documentary evidence is available, the policy statements made
by management are treated as the ilecessary evidence.
Historical Record Concept: You know that after identifying the transactions and
measuring them in terms of tnoney we record them in the books of account. According to
the histotical record concept, we rec~rd only those transactions which have actually taken
place and not those which lnoy take place (future transactions). It is because accounting
rgcord presupposes that the transactions are to be identified and objectively evidenced. This
is possible only in the case of past (actually happened) transactions. The future transactions
can hardly be identified and measured accurately. You also know that all transactions are to
be recorded in chronological (datewise) order. This leads to the preparation of a historical
record of all transactions. It also implies that we simply record the facts and nothing else.
As you will study later, we also make provision for soine expected losses such as doubtful
debts. This may be contrary to what is stated in historical record concept. But tl~is is done
only at the time of ascertaining the profit ar loss of the business. It is not a routitre item.
This is done in accordance with another concept called Co~iservatism Concept about which
you will study later.
Cost Concept: Business activity, in essence, is an exchange of money. The price paid (or
agreed to be paid in case of a credit tl-ansaction) at the time of purchase is called cost.
According to the cost concept, all assets are recorded in books at their original purchase
price. This cost also for~ns an appropriate basis for all subsequent accounting for the assets.
For example, if the business buys a machine for Rs. 80,000 it would be recorded in books at
IPS. 80,000. In case its market value increases to Rs. 1,00,000 later on (or decreases to Rs.
50,000) it will continue to be shown at Rs. 80,000 and not at its market value.
This does not mean, however, that the asset will always be shown at cost. You know that
with passage of time the value of an asset decreases. Hence, it may systematically be
reduced from year to year by charging depreciation and the asset be shown in the balance
sheet at the depreciated value. The depreciation is usually charged as a fixed percentage of
cost. It bears no relationship with changes in its market value. In other words, the value at
whicl~ tile assets are shown in the balance sheet has no relevance to its market value. This,
110 doubt, makes it difficult to assess the true financial position of the business and is
therefore regarded as an irtiportarlt li~llitation of the cost concept. But this approach is
preferred because, firstly it is difficult and time consuming to ascertain the market values,
and secondly there will be too much of subjectivity in assessing tlie current values.
However, this limitation has been overcome with the help of inflation accounting.
Dual Aspect Concept: This is a basic concept of accounting. According to this cor~cept
every business transaction has a two-fold effect. In commercial context it is a famous dictum
that "every receiver is also a giver and every giver is also a receiver". For example, if you
purchase a machine for Rs. 8,000, you receive machine on the one hand and give Rs. 8,000
on the other. Thus, this transaction has a two-fold effect i.e., (i) increase in one asset and (ii)
decrease in another asset. Similarly, if you buy goods worth Rs. 500 on credit, it will
increase an asset (stock of goods) on the one hand and increase a liability (creditors) on the
other. Thus, every business transaction involves two aspects: (i) the.receiving aspect, and (ii)
the giving aspect, In case of the first example you find that the receiving aspect is machinery
and the giving aspect is cash. In the second example the receiving aspect is goods and the
giving aspect is the creditor. If complete record of transactions is to be made, it would be
necessary to record both the aspects in books of account. This principle is the cose of double
enuy book-keeping and if this is strictly followed, it is called 'Double Entry System of
Book-keeping' about which you will learn in detail later.
Let us understand another accounting implication of the dual aspect concept. To start with,
the i~litial funds (capital) required by the business :ire contributed by the owner. If necessary,
additional funds are provided by the outsiders (creditors). As per the du:11 aspect concept all
these receipts creaLe corresponding obligations for their repayment. In other words, a
contribution to the business, either in cash or kind, not only increases its resources (assets),
but also its obligations (liabilities/equities) correspondingly. Thus, at an;. riven point of
time, the total assets and the total liabilities must be equal.
This equality is called 'balance sheet equation' or 'accounting equation'. It is stated as
under :
Liabilities (Equities) = Assets
or
Capital + Outside Liabilities = Assets
The term 'assets' denotes the resources (property) owned by the business while the term
'equities' denotes tl~e claims of various parties against the business assets. Equities are of
two types: (i) owners' equity, and (ii) outsiders' equity. Owners' equity called capital is the
claim of the owners against the assets of the business. Outsiders' equ'ity called liabilities is
the claim of outside parties like creditors, bank, etc. against the assets of &e business. Thus,
all assets of the business are claimed either by the owners or by the outsiders, Iience, the
total assets of a business will always be equal to its liabilities.
When various business transactions take place, they effect the assets nnd liabilities in such a
'way that this equality is always maintained. Let us take a few transactions and see how this
equality is maintained.
1 Mr. Gyan Chand started business with Rs. 50,000 cash: The cash received by the
business is its asset. According to the business entity concept, business and the owner
are two separate entities. Hence, the capital contributed by Mr. Gyan Chand is a liability
to the business. Thus :
Capital = Assets
Rs. 50,000 = Rs. 50,000 (cash)
2 He purchased goods on credit from Chakravarty for Rs. 5,000: This increases an
asset (stock of goods) on the one hand and a liability (creditors) on the other. Now the
equation will be :
Capital + Liabilities = Assets
Rs. 50,000 + Rs. 5,000 = Rs. 5,000 + Rs. 50,000
Capital Creditors Stock Cash
3 He purchased furniture worth Rs. 10,000 and paid cash: This increases one asset
(furniture) and decreases another asset (cash). Now the equation will be :
Capital t Liabilities = Assets
Rs. 50,000 + Rs. 5,000 = Rs. 10,000 + Rs. 5,000 + Rs. 40.000
Capital Creditors Furniture Stock Cash
This equation can be presented in the form of a Balance Sheet (a statement of assets and
liabilities) as follows :
1.3.2 Concepts to be observed at the reporting stage
The following concepts have to be kept in mind while preparing the final accounts.
1 Going Concern Concept
2 Accounting Period Concept
3 Matching Concept
4 Conservatism Concept
5 Consistency Concept
6 Full disclosure Concept
7 Materiality Concept
You will learn abour these concepts in Unit 6.
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