Accounting Principle and Accounting Assumptions – Class 11, Important

1. Accounting Entity or Business Entity Principle

According to this accounting principle, a business is considered to be a separate and distinct entity from its owners.

• Accounting is always done from the point of view of the business and not its owners. So, all the business transactions are recorded from the point of view of the business and not from that of the owners.
• The personal transactions of the owner are kept separate from the business. For example, house, car, personal income, and expenditure of the proprietor must be kept separate from the business accounts.
• The proprietor or owner is treated as a creditor of the business to the extent of capital invested by him in the business. When the owner brings in some money as capital, it is treated as a liability of the business to the owner. Similarly, when he withdraws money from the business for his personal expenses (drawings), it is treated as a reduction of the owner’s capital and consequently a reduction in the liabilities of the business.
• This principle applies to all forms of business organizations, i.e., sole proprietorship, partnership, or a company.

2. Money Measurement Principle

According to this accounting principle, only those transactions and events are recorded in the books of accounts that are capable of being expressed in terms of money,

• Suppose a business enterprise has  70,000 cash, 2 buildings, and 4 machines. These assets cannot be added and shown in the Financial Statements unless they are valued in terms of money and then added up together to know the worth of the business. So, money is the common denominator in which all transactions are recorded.
• This concept suffers from two major limitations:

(i) Qualitative transactions are not recorded, irrespective of their importance. For example, sincerity and quality of the employees or quality of the product are not recorded in the Financial Statements even though they are so crucial for the enterprise.

(ii) Money is considered to have static value as transactions are recorded at the value on the transaction date. However, the value of money does not remain the same over a period of time due to changes in the price level.

Also Check Out: 20 transactions with their Journal Entries, Ledger and Trial balance to prepare project

3. Accounting Period Principle

According to this accounting concept, the economic life of an enterprise is split into periodic intervals (known as the accounting period) so that its performance is measured at a regular period.

• The accounts of an enterprise are maintained following the Going Concern Concept, which says that the business is intended to continue for an indefinite period of time. It means that the true results of the business operations can be ascertained only when the business is completely wound up.
• However, ascertainment of profit after a very long period will be of little use to the users of financial statements as they need accounting information at regular intervals for decision making.
• So, the life of a business is split into periodic intervals, which is known as the ‘Accounting Period”.
• An accounting period of one year is usually adopted for this purpose. In India, it generally starts on 1t day of April and ends on 31t of March next year.
• At the end of an accounting period:
• Profit and Loss Account is prepared to know the profit earned during the accounting year; and
• The Balance Sheet is prepared to know the financial position of the business at the end of the year.

4. Full Disclosure Principle

According to this fundamental accounting principle, the financial statements should completely disclose all the significant information relating to the economic affairs of the enterprise.

• The disclosure can be done either in the financial statements or in the footnotes, like in the case of contingent liabilities (or Notes to Accounts in case of companies).
• Full Disclosure is not only a legal requirement, but it also makes the accounting system fair and transparent.
• As per the Companies Act, every company is required to disclose essential information in the financial statements.
• Incomplete information hampers the basic purpose of financial statements. So, all the material and relevant facts should be disclosed in the financial statements.
• Full Disclosure ensures that financial statements present a true and fair view of the profitability and financial position of the business to its various end-users.

5. Materiality Principle

This accounting principle states that all relatively relevant items, the knowledge of which might influence the decision of the users of the financial statements, should be disclosed in the financial statements.

• As per this Materiality, only those items should be disclosed that have a significant effect or are relevant to the user. So, this principle is contradictory to the Full Disclosure principle.
• An item that is significant for one enterprise, maybe insignificant for another enterprise. For example, tools costing 5,000 is material for small car workshop, but for a large enterprise, like Tata Motors, it may be insignificant.
• So, whether an item is material or not will depend on its nature arid/or amount.

6. Prudence or Conservatism Principle

Conservatism accounting principle determines tha, all prospective losses should be recorded in the books of accounts, but all anticipated profits should be ignored.

• Due to this principle, provision is made for all known liabilities and losses, even though their amount cannot be determined with certainty, For example, provision for doubtful debts is made in anticipation of actual bad debts. Similarly, the closing stock is valued at a lower cost or net realizable value.
• This principle aims to ensure that the Financial Statements present a true and fair view of the state of affairs of the business and does not exhibit a better picture than what actually is.

Drawbacks of Conservatism Principle

(i) It may lead to the creation of Secret Reserves: The creation of too many provisions, like creating excess provision for doubtful debts or charging excessive depreciation, may lead to the creation of secret reserves.

(ii) It may lead to an overstatement of liabilities: Conservatism provides for all the anticipated expenses and losses but does not record anticipated revenues. So, it may result in the overstatement of liabilities. So, this principle should be carefully applied so that the results depicted by the Financial Statements are not distorted.

7. Cost Concept or Historical Cost Principle

Historical Cost accounting Principle states that an asset is recorded in the books at the price paid to acquire it and cost becomes the basis for its accounting in the subsequent accounting periods.

• The asset is recorded at cost at the time of its acquisition and is reduced year after year by charging depreciation based on the useful life of that asset rather than its market value. So, an asset is shown in the Balance Sheet at its book value, i.e. cost less depreciation.
• If nothing is paid to acquire an asset, then the same will not be recorded as an asset.
• Since the acquisition cost of an asset relates to the past, it is referred to as ‘Historical Cost’.
• This principle brings Objectivity in the preparation of financial statements as the cost price paid for the purchase of assets is verifiable from the cost records. So, the information stated in the financial statements is not influenced by personal bias or judgments.

Drawbacks of Cost Principle

1. It ignores the recording of assets for which nothing in monetary terms is paid. For example, a good brand name, favorable location, technological knowledge, etc. will remain unrecorded even though these are valuable assets.
2. It results in inflated or understated profit during inflation as depreciation is charged on the basis of historical cost and not on the basis of market value.

8. Matching Principle

It is a fundamental accounting principle that states that all expenses incurred during an accounting period should match the revenues recognized in that period.

• Profit earned by a business during a period can be correctly measured only when the revenue earned during the period is matched with the expenditure incurred to earn that revenue. Such matching of revenue with expenses is based on the accrual system of accounting.
• The following are the points that should be kept in mind for matching cost with revenue:

(a) When an item of revenue is included in the Profit and Loss Account, then all the expenses incurred, whether paid or not, should be shown as expenses in the Profit and Loss Account. It means that if there is any outstanding expense, then will be shown in the Profit and Loss Account.

(b) If an expense is paid during an accounting period, but revenue related to it will be earned in the following period, then such expense will be shown as an expense only next year and not this year. For example, Prepaid Insurance. Such prepaid expense is shown as an asset in the Balance Sheet.

(c) In the same manner, if revenue is received, but against it, services will be rendered next year, then revenue will be also recognized in the next year and will be shown as a liability in the Balance Sheet. For example, unearned salary.

Also Read: 30 transactions with their Journal Entries, Ledger, Trial balance and Final Accounts- Project

9. Dual Aspect or Duality Principle

Every business transaction has two aspects, a debit and a credit of an equal amount. In order to understand this principle, let’s take an example:

Let’s imagine you start a small bakery. You invest ₹50,000 of your own money (capital) to get started. This transaction has two effects.

1. Increase in Assets: Your bakery’s cash (an asset) increases by ₹50,000.
2. Increase in Equity: Your owner’s equity (capital) also increases by ₹50,000.

This transaction maintains the balance of the accounting equation:

• In other words, for every debit, there is a credit of equal amount in one or more accounts and vice-versa. The system of recording transactions based on this principle is termed as ‘Double Entry System’.
• Because of this accounting principle, the Balance Sheet has two sides: The assets side and the Liabilities side and both are always equal to each other under all circumstances.
• For example, suppose Rachit starts a business by investing 4,00,000 in cash and takes a loan of 1,00,000 from the bank.
• Now, the assets (cash) in the business will increase by 5,00,000 (4,00,000 + 1,00,000).
• At the same time, it will increase the owner’s equity or capital by 5,00,000; and
• Claims of outsiders, i.e. liabilities will increase by 1,00,000.
• Now, this transaction can be expressed as Assets (Cash) = Claim of Outsiders (Bank Loan) + Owner’s Equity (Capital)
• This fundamental equation will always remain good in all situations.

10. Revenue Recognition Accounting Principle

The following principle states that, revenue must be recognized when a transaction has been entered into and the obligation to receive its payment has been established.

• It is very important to decide the point of time when revenue can be assumed to have been recognized as revenue recognized is only considered for computation of profit.
• Example: Suppose a firm sells goods in January 2016 but receives the amount in March 2016. As per the principle of revenue recognition, revenue from this sale should be recognized in January 2016 itself as the legal obligation to pay the amount has been established on this date. However, if the firm had received only an advance in January 2016 for the sale of goods in April 2016, then revenue from this sale shall be recognized in April 2016.

11. Verifiable Objective Concept

As per this concept, all transactions should be recorded in an objective manner and they should be free from personal bias,

• It implies that all accounting transactions should be supported by documentary evidence or vouchers.
• These supporting documents include cash memos, invoices, bills, etc.
• For example, cash purchases of goods should be supported by a Cash Memo and credit purchases by an invoice.

Also Read: Meaning of Depreciation