BASIC CONCEPTS USED IN PREPARATION OF FINANCIAL STATEMENTS
BASIC CONCEPTS USED FOR THE PREPARATION OF FINANCIAL STATEMENTS
In accountancy, there are different rules and principles known as accounting concepts and conventions which are used to record economic events and for the preparation of financial statements. All the accountants are required to follow these concepts and conventions while preparing the financial statements. Some of the accounting concepts which are fundamental in nature will be discussed in this article such as the concept of accrual, prudence, matching, consistency & Going Concern.
These concepts relate to the different aspects of the financial statements and some of them are explained below:
- Entity Concept
- Realization Concept
- Going Concern Concept
- Money Measurement Concept
- Cost Concept
- Dual Aspect Concept
- Prudence Concept
- Stable Monetary Unit Concept
- Objectivity concept
- Substance concept
BUSINESS ENTITY CONCEPT
For all accounting purposes, owners are treated as separate and distinct persons from the business. This is a reason why owners become claimants against their own businesses for their investment in the business capital.
As per the business entity concept, there has to be some distinction between the businesses and their owners in the books of accounts.
In case of proprietorship and partnership firms, there exists clear legal distinction between the owners and their businesses.
For the purpose of accounting in limited companies, these distinctions might be irrelevant and the concept of business entity is applicable to all the businesses.
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As per the concept of realisation, the revenue should be recognised only when the goods or services from which revenue is earned have been delivered or rendered as the case may be, i.e to say revenue will be recognised only after it has been earned.
This principle of realisation is one of the most common principles which gets violated whenever companies want to show increased revenue by booking the income in advance of all the earning activities which still remain to be completed.
CONCEPT OF MONEY MEASUREMENT
Only those transactions are dealt in the accounting which can be expressed in terms of money. Money is one common denominator which is used to express various resources which are held by the business.
But it should be remembered that not all of such resources can be measured in terms of money and therefore, gets excluded from the items of the balance sheet. This one concept of Money Measurement has limited the scope of accounting reports.
GOING CONCERN CONCEPT
As per the going concern concept, it is assumed that business will continue its operations in the future. That is to say, there is no possible intention or the need to sell all of the business assets.
This kind of sale could be the result of initial difficulties faced by the business and as is needed to pay off the creditors.
This is an important concept because the value of fixed assets depends on the intention of the fact whether the business will be continued or not. Because if fixed assets were to be sold, they will fetch a lower amount than they have been reported for.
And if it is expected that the assets will be sold off, that would mean that any anticipated losses on such sales have to be provisioned. But if there is no such expectation of selling these assets, the value of assets can be continued to be shown at the recorded values. This way, going concern concept sports the concept of historical cost under general circumstances.
HISTORIC COST CONCEPT
The value of items which are shown in the balance sheet, are based on their acquisition cost. It is the most common method to measure the value of assets which has been adopted by accountants and is preferred to the other methods of measurement. Although there are many commentators who find this convention outdated because it fails to show the current financial position.
It has been often said that a more realistic view of financial position will be provided if the asset were to be recorded at the current value instead of the historical values and it will also provide relevant information to take a wide range of the decisions.
But it has to be considered that, if assets were to be recorded at their current selling value, it will lead to a number of problems.
DUAL ASPECT CONCEPT
There are two aspects in every transaction and both of those aspects affect the balance sheet. For example: The purchase of a computer system will lead to outflow of cash with an increase in one asset (Computer) and decrease in another (Cash).
For every transaction, it is going to lead to an increase in one thing and decrease in another i.e for every inward, there is an outwards.
This concept states that financial statements should always remain on the side of caution. The concept of prudence scheme arose after managers and owners started to show excessive optimism which resulted in the overstatement of the financial position of the businesses.
As per the prudence concept, transactions should be recorded for both actual as well as anticipated losses in full while profit should not be recognised at all until, they are actually realised that is to say the profit will be certainly received.
In case any inconsistency arises in the application of the Concept of Prudence, with another concept, the concept of prudence will prevail.
STABLE MONETARY UNIT CONCEPT
As per the stable monetary unit concept, also often known as the consistency concept, the measurement unit which is used in the accounting will not change over a period of time.
Having consistency is very important for any business because as per this concept, the like items in the business should be given the same accounting treatment and that should continue from one period to the next.
For example: One particular method of depreciation should be used for every financial year instead of switching them, and the tools and equipment which are purchased are being treated as fixed assets in one year, then they should also be treated as fixed assets in the subsequent years.
This concept enables comparison between two different accounting periods and also decreases the possibility of misrepresentation.
As per the concept of objectivity, effort should be made to decrease any personal perceptions while making or preparing the financial statements. Rather than based on opinions, the financial statements should be based on objectivity and actual evidence which is verifiable.
This concept holds that substance should always be placed over the form (legal form of the transaction). i.e there could be a difference in legal form of a substance and its real form and accounting should show the transaction as per the real substances instead. In other words, the accounting should present how the transaction affects the financial situation of the business.