The business is treated as a distinct (and separate) entity from the individuals who own it and accordingly accountants record transactions. For example, if the owner of a shop withdraws Rs. 10,000 for personal use, from the business entity point of view, the entity has less cash though it belongs to the owners. Therefore, this amount is shown as a reduction in owner’s capital, which in view of business entity concept appears as a liability in the balance sheet of the business. Without such a distinction the affairs of the shop will be
Pure Accounting Viewpoint : We will start from the fundamental accounting equation, that is:
Debit = Credit (i)
And, Assets = Liabilities (ii)
And, Assets = Internal Liabilities + External Liabilities (iii)
And finally, Assets = Capital + Liabilities; or A = C + L (iv)
A record is made only of the information that can be expressed in monetary terms for accounting purposes. The advantage of doing this is that money provides common denominators by means of which variety of facts can be expressed as numbers that can be added and subtracted. This enables addition and subtraction of varied items since money provides the common denominator. An event even though important like the loyalty of the workers will not be recorded unless it can be expressed in monetary terms. The changing price level also creates difficulties in the monetary value.
If we look at financial accounting purely from the point of view of Fundamental Accounting Equation:
Assets = Capital + Liabilities,
then it would be evident that it had virtually no option but to adopt monetary values of assets and liabilities and capital to apply the equation in day-to-day business affairs. This concept is basically concerned with the problem of measuring items of the accounting equation. Such items may be plant and machinery (assets), liability for loan taken – all these are object of some kind of the other.
Other items represent events (transactions) such as expenses and income. Basically, double entry system is additive (say, when finding the aggregate of assets) or subtractive (say when total liabilities are deducted from total assets to find capital, or deducting expenses from income to estimate profit). But only the "like" can be added with the "like" and the "like" can be deducted from the "like", when the word "like" means that the items involved are expressed in the same unit. But in real-world affairs, physical assets may have to be expressed in several ways, like numbers of units, weight, volume, etc. Likewise wages may have to be expressed in man-hours or simply in hours.
Apart from ensuring feasibility of making addition and subtraction, which is inherent in the accounting equation, the sign of equality (actually the sign of "identity") needs use of the
In modern business it is essential link to accounting to a market system in an exchange economy a valuable source of quantitative data. Since goods and service are generally exchanged in terms of money, a monetary measurement of economics data can be assumed to be useful in decision-making, particularly for that decision relating to wealth and the production of goods and services.
The cost concept and the money measurement concept go hand in hand. Transactions are recorded in the books at the price paid that is the cost. This avoids an arbitrary value being placed on the asset and all subsequent accounting is in relation to the cost.
Therefore, the recording of the assets is at cost figures and this may not reflect the current market value especially in the case of the older assets. The value of an asset in the accounting records does not remain at the original cost because it is diminished systematically by virtue of its use called expired cost and then shown at its depreciated value e.g. an asset of Rs. 1,00,000 is depreciated at 10%.
Therefore, closing value will be Rs. 90,000 in the Balance Sheet. An expired cost is an expenditure of money, the economic value of which has been made use of during a particular year (or lost without accruing any benefit to the entity, like machinery destroyed by flood).
Every cost has to be recovered from the market through sales, otherwise, the entity will suffer loss, that is, lose its capital. Depreciation, looked at from this viewpoint, is nothing but gradual recovery of cost incurred, that is, money paid at a time during a particular year for acquiring a fixed asset, during the subsequent years (during which the asset is assumed to remain serviceable) on some estimated basis, by treating the expired cost pertaining to a particular year, calculated on some approved and selected estimated basis, by including such expired cost, called an expense, in the cost of production of that particular accounting year.
Linking annual depreciation with the expected service life of a fixed asset does not endow any scientific logic on any estimated basis of depreciation. In accounting, depreciation is nothing more and nothing less than a process of allocation of some specific costs (cost of acquiring fixed assets) on some generally accepted (may or may not be legally approved) estimated basis.
An expired cost is not a money measure of the wear and tear obsolescence (passage of time) etc. of any fixed assets. It is just a reasonable basis for recovery of cost of fixed asset in a gradual manner. Money value of wear and tear would need engineering analysis, which is not the domain of financial accounting.
In essence, in a little more technical sense, cost represents the exchange price agreed upon by the buyer and the seller in a relatively free economy. Cost has been the most common valuation concept in the traditional accounting structure.
Therefore, cost is the exchange price of goods and services at the time they are acquired. So, cost is also the economic sacrifice expressed in monetary terms required to obtain a specific asset or a group of assets. Very often cost is not represented by a single exchange price, but it includes many sacrifices of economic resources necessary to obtain the asset in the form, location and time in which it can be useful to the operating activities of the firm.
Accounting assumes that the business will exist indefinitely into future and accordingly transactions are recorded. If however, there is evidence that the firm will be liquidated then market value of the assets and liabilities will be ascertained and necessary accounting considered. In other cases where the business is an on-going activity resale value of assets is irrelevant. The whole accounting is done based on this assumption.
The present concept as well as the earlier Business Entity concept belongs to the category of "Environmental Postulates of Accounting". It is important to know the precise meaning of this expression, for which purpose we have to know what an accounting postulate is and what is environmental in accounting. In order to avoid a lengthy discussion, we may summarise, by stating that postulates are basic assumption or fundamental propositions concerning the economic, political and sociological environment in which accounting must operate. Thus, it is clear that certain economic, political and sociological events do affect the thinking and actions of accountants and we must also clearly understand that every such event does not affect accounting concepts and practice. The basic criteria for any such postulates are:
(1) They must be relevant to the development of accounting logic, that is, they must serve as a foundation for the logical derivation of further propositions; and
(2) They must be accepted as valid by the participants in the discussion as either being true or providing a useful starting point as an assumption in the development of accounting logic.
The economic resources of an entity are assets and the
acquisition of an asset must be on account of : –
(a)
some other assets being sold ; or
(b)
the creation of an obligation to pay ; or
(c)
there has been a profit owed to proprietor ; or
(d)
the owner has contributed.
On the other hand, an increase in liability is on account of an
increase in asset or a loss. Therefore, at any time –
Assets =
Liabilities + Capital
Capital = Assets –
Liabilities
The owner’s share is what
is left after paying outsiders. This is the accounting equation. Every
transaction has dual impact and accounting systems record both the aspects and
are called the double entry system. e.g. X starts a business with a capital of
Rs.20,000. There are two aspects of the transaction. On the one hand the
business has assets of Rs. 20,000 while on the other hand it has to pay the
proprietor Rs. 20,000, therefore: –
Capital (Equities)
= Assets (Cash)
Rs. 20,000 = Rs.
20,000
What has been stated above
is an oversimplified version of the concept and its application, since this is
the form of the concept with which we are familiar as beginners. But we have to
go a little deeper in order to have a more meaningful understanding of the
concept because it is the bedrock on which double entry book keeping has built
its gigantic edifice and is still flourishing as a very important discipline
all over the world.
There must be something deeper than what has been stated
above which caught the imagination of an Italian priest and mathematician and
prompted him to codify if not invent the double-entry system in 1495 which
explained logically and systematically what happens in the economic world, in
terms of money when goods are manufactured and sold at the market place through
financial transactions. This could be applied to sale of services equally
logically, and systematically. In course of time it also exposed other related
concepts, especially the first two concepts already discussed, namely the
Business Entity concept and the Money Measurement concept.
The realisation concept
indicates the amount of revenue that should be considered from a given
transaction. Realization refers to inflows of cash or claims to cash. It states
that the amount recognized as revenue is the amount that is reasonably certain
to be realised. Sometimes there is scope for difference of judgement as to how
to ascertain "reasonably certain". A situation arises when a company
makes a credit sale and expects that the customer will pay their bill.
Experience shows that not all customers pay their bill. In measuring the
revenue for a period, the amount of credit sales that will not be realised
should be reduced by the estimated amount of credit sales that will never be
realised i.e. by estimated amount of bad debts.
Example: If a company makes a
credit sale of Rs 100,000 during a period and experience indicates that 2% of
credit sales will become bad debt, the amount of revenue for the period is Rs
98,000 and not Rs 100,000. It does not anticipate events and stops the business
from inflating their profits by recording sales and incomes likely to accrue.
Unless money has been realised as cash or legal obligation to pay on sale,
profit or income is considered e.g. M places an order with N for supply of
certain goods yet to be manufactured. On receipt of order N purchases raw
materials, employs workers, produces goods and delivers to M. M makes payment
on receipt of goods. In this case the sale is not at the time of receipt of
order but at the time when goods are delivered to M.
Profit arises only out of
business operation when there is an increase in the owner’s share of the
business and not due to his contribution to the business. Any increase in
owner’s equity is called revenue and any reduction in it termed as a loan. In
fact, it is the direct outcome of Realisation Concept (already discussed) and
the Accounting Period concept (to be discussed). In a way, realisation concept
has been split up into two parts, namely, production of economic goods or
rendering of economic services, and realisation of due revenue.
Any uncertainty
about any of the two elements beyond what is considered uncontrollable will not
permit the accountant to treat the money value or cash equivalent of the sale
price to be considered as realised income. Another very vital element is
involved in between, that is, a third one, namely acquiring legal right to
claim the price of the goods delivered or fees for services rendered. Acquiring
the legal right to claim the consideration for goods/services is called accrual
of revenue, which usually precedes collection. However, in case of cash
transactions, under the accrual method P/L A/c and Balance Sheet are prepared
on the accrual basis, in the absence of any uncertainty about collection.
This
does not mean that collection has been given less importance than economic
value adding and the right to claim the purchase consideration. With
uncertainty about collection, it is meaningless and dangerous to take income
into account as having been realised. In fact, ability to pay, is considered by
the supplier of goods and services before one decides to sell his products or
render his services to another. Then after the deal is finalised, goods have
been delivered or services rendered and legal right to claim the purchase
consideration has been acquired, collection is taken up as a specialised
process to ensure return of capital and earning of profit.
The other pressure
comes from the Accounting Period convention. Production is a continuous
process. True profit is cash profit during the entire lifetime of an
enterprise. Then and then only we know total money collected and spent by it
during its lifetime. But the way our culture has bound us up with annual
profit, annual income and other periodic results, we have divided the entire
life-span of our organisation into several chapters, each chapter being an
accounting period or an accounting year. A year consists of 12 months. This is
very significant, because each period being equal in terms of time frame, it
facilitates comparison of performances.
Because of this Cost Accountants divide
a year in 13 months, each period consisting of 4 weeks. The process of dividing
the life span of a company into time–chapters which is an artificial man-made
process, though production follows a continuous flow, gives rise to certain
accounting problems. For example, at the time of closing of period/annual
accounts, production and sale might have been completed, local right to claim
the sales value have been acquired, but payment has not yet come through.
The accounting reports
measure activities for a specified interval of time called the accounting
period, which is usually one year and therefore termed as annual reports.
Interim reports in between may be compiled especially for internal users.
Except for those ventures which are predetermined to end on the completion of a
specific task or a specific time-frame, every enterprise, profit-oriented or
not, desires to enjoy perpetual existence as a going (running) concern, making profits,
grow and distribute profits judiciously.
This calls for recognition and
measurement of incomes and expenses and to match them to ascertain profit. But,
the concept of profit is time-related. Hence, the question: profit for what length
of time? Theoretically, the most correct reply would be the entire life–time of
an enterprise. That means no measurement of income until an enterprise is wound
up. But human beings inherently, desire to know, periodic performances mainly
for the purpose of comparison, which would not be possible, different firms
wind up after different lengths of time. Moreover, from the practical point of
view, some firms may not close down during a number of successive generations.
Hence no income tax for ages, too. Let us not extend the list of such fanciful
but important (academically) possibilities. Thus, out of practical
considerations, businessmen, sided by accountants, divide the life span of an
entity into a number of chapters of equal duration, usually a twelve-month
period.
Thus one phase of activities of an enterprise is deemed to have passed
– one chapter is closed. Such a 12-month chapter is called accounting period.
And financial accountants prepare a P/L A/c. for that period to estimate its
operating result, that is, profit or loss and the financial position as at the
end of the period in terms of assets, liabilities (external) and owners’ equity
(internal liability).
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