An Overview of

Fundamental Accounting
Concepts & Principles

Dr. Kavitha Menon

Accounting Concepts

● The assumptions and conditions on the basis of

which financial statements of a business entity are
prepared.
● Certain concepts are perceived, assumed and
accepted in accounting to provide a unifying
structure & internal logic to accounting process.
● They lay the foundation on the basis of which the
accounting principles are formulated.
 Accounting Principles

● Uniform practices or a body of doctrines that entities

follow to record, prepare and present financial
statements
● An entity must prepare its financial statements as per
acceptable accounting principles in order to present a
true and fair view of the state of affairs of the entity.
● In India, general accounting principles are accounting
standards and Indian Accounting Standards.
 Accounting Conventions

● Emerge out of accounting practices

● Customs & traditions derived by usage and practice.
● Need not have universal applications
Accounting concepts, Accounting Principles & Accounting
Conventions are used interchangeably to mean those basic
points of agreement on which financial accounting theory &
practice are founded
CONCEPTS, PRINCIPLES &
CONVENTIONS
 Bird’s Eye View

1. Entity Concept 8. Matching Concept

2. Going Concern Concept 9. Realization Concept
3. Money Measurement Concept 10. Objectivity Concept
4. Cost Concept 11. Conservatism/Prudence
5. Dual Aspect Concept 12. Consistency
6. Periodicity Concept 13. Full Disclosure
7. Accrual Concept 14. Materiality
 ENTITY CONCEPT
● For accounting purposes, an “organization” is treated as a
separate entity from the “owners” or “stakeholders”. Hence,
Business is distinct from its owners and has a separate identity.
● Helps in keeping personal transactions of the owners and
stakeholders separate from the business affairs
● Entity is liable to the owner for the capital investment made by
the owner. Hence owner has a claim on the profits of the
enterprise.
● Sole proprietorship & partnership concerns are NOT separate
entities in the eyes of law but in accounting, they are separate.
 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 i.e. business
will continue for an indefinite time.
● Assumes the enterprise has neither the intention nor the
necessity to liquidate or curtail the scale of its operations.
● The concept indicates that assets are kept for generating
benefits in future, not for immediate sale
 GOING CONCERN CONCEPT

● It is due to this concept that:

○ Proper distinction is made between capital & revenue

expenditure

○ Assets are classified into fixed assets & current assets

○ Liabilities are classified into short term liabilities & long

term liabilities
MONEY MEASUREMENT CONCEPT

● Only those transactions which can be measured in terms of money are

recorded, as money is the medium of exchange and the standard of
economic value.
● Transactions, even if they considerably affect the results of the
business are not recorded in the books of accounts if they are not
convertible in monetary terms
● E.g. A team of dedicated & trusted employees, inefficient
management, lack of coordination between managers – non-monetary
● This concept has its own limitations & inadequacies.
MONEY MEASUREMENT CONCEPT

● Measuring unit for money – Currency of the ruling country

● E.g. a business owns cash of ₹ 10,000, 600kgs of raw materials, 2
trucks, 1000 square feet building space etc – cannot be added up
together to produce a meaningful total. But they can be expressed in
monetary terms

● IT IS NOT TRUE THAT ACCOUNTING GIVES A FULL PICTURE

OF A BUSINESS. THIS IS BECAUSE NO RECORD IS MADE FOR
NON-MONETARY ITEMS.
COST CONCEPT

● The value of an asset is to be determined on the basis of

historical cost i.e. acquisition cost., the price paid to
acquire the asset.
● When a machine is acquired by paying ₹5 lakhs,
following cost concept the value of the machine is taken
at ₹5 lakhs. Proper documents will be available as proof
- highly objective & free from bias.
● Market value is a subjective term.
● This cost is the basis for all subsequent accounting for
that asset.
COST CONCEPT

● Example: A plot of land was purchased for ₹ 150,000. The

asset will be recorded in the books at ₹150,000, even if its
value at that time is ₹ 200,000. After a year even if its
value comes down to ₹ 100,000, it will continue to be
shown at ₹ 150,000.
● This does not mean the asset should always be stated at
cost. At the time of purchase, it is at cost and it may be
systematically be reduced in its value by charging
depreciation.
COST CONCEPT

● Drawback of this concept

○ Inflationary situation – land is purchased during the

year for ₹50,000 and end of the year its market value is
₹200,000. Financial statements will not give a true and
fair view.

○ Asset does not have any acquisition value (gifts), such

assets will not be shown in the books if cost concept is
followed as nothing is paid. Financial statements will
not give a true and fair view.
 DUAL ASPECT CONCEPT
● This concept is the core of double entry book-keeping.
● Every transaction has a dual aspect:
A. It increases one asset and decreases other asset (Furniture
purchased for Cash)
B. It increases an asset and simultaneously increases liability.
(Furniture purchased on credit, Commission received)
C. It decreases a liability & decreases an asset (repayment of
bank loan in cash)
D. It increases one liability & decreases other liability
(acceptance of bills payable, conversion of debentures
into equity)
DUAL ASPECT CONCEPT

● Based on this concept is the

Accounting Equation:
ASSETS = LIABILITIES + CAPITAL
 PERIODICTY CONCEPT
● Also called concept of definite accounting period.
● As per going concern concept, an indefinite life of the entity is
assumed.
● Measurement of financial performance & position after a very
long period would not be helpful in taking corrective actions
within the right time.
● If a textile mill lasts for 100 years, it is not desirable to measure
its performance as well as financial position only at the end of
its life.
● So, a small and workable fraction of time is chosen out of the
infinite life cycle of the business for measuring performance
and looking at financial position
 PERIODICTY CONCEPT
● Hence, life is divided into time intervals and after every time
interval, the business must ‘stop’ and ‘see’, ‘how things are
going’
● This time interval is the accounting period
● One calendar year i.e. 1st April of a year to 31st March of the
immediately following year.
● This helps in comparison, following of uniform and consistent
accounting treatment and matching of revenue with expenses.
● Allocation of expenses into capital & revenue
 ACCRUAL CONCEPT

● All revenues should be recognized when they are earned

(when sale is made). It is immaterial whether cash is
received or not
● Similarly, expenses are recognized & recorded in the
accounting period in which they are incurred whether cash
is paid or not
● This concept is based on matching concept.
Example
● Mr. X buys clothing of Rs. 50,000 paying cash Rs. 20,000. He
sells the clothing at Rs. 60,000, of which customers paid only
Rs. 50,000.
● His revenue is Rs. 60,000, not Rs. 50,000 cash received.
● Expense (i.e. cost incurred for revenue) is Rs. 50,000 and not
Rs. 20,000 cash paid
● So, accrual concept based profit = Rs. 10,000 (Revenue –
Expenses)
Example
● A building is taken on rent for the purpose of business on 1st
May at ₹5000 per month. The financial year ends on 31st
March.
● Rent was paid for 10 months.
● Total rent for 11 months should be shown in the P&L a/c,
irrespective of the actual amount paid for rent during the year.
MATCHING CONCEPT
● Based on the accounting period concept.
● To ascertain the profit of a period, the cost of the period
should be matched with the revenue of that period.
● This is also based on the accrual concept as it considers
occurrence of income & expenses & not on the flow of cash
● When an item of revenue is entered in the P&L a/c then all the
expenses incurred to earn that income whether paid or not,
should be entered on the expenses side.
MATCHING CONCEPT
● When some amount is spent in the current year and the
income against it will be earned in the subsequent years, then
the expenditure should be shown in the subsequent years when
the income is earned
● Outstanding expenses to be added to expenses
● Prepaid expenses to be deducted from expenses
● Closing stock should be carried over to the next period as
opening stock
● Accrued income to be added to revenue
● Income received to advance to be deducted from revenue
Question

1. What’s the revenue to be recorded under accrual concept?

2. What’s the shop rent to be recorded ?
3. Should the accountant treat Rs. 10,00,000 as expense for
purchase of merchandise?
4. How much is the profit?
5. How much are the assets?
6. How much are the liabilities?
Accrual, matching and periodicity
concepts work together for income
measurement and recognition of
assets & liabilities
REALIZATION CONCEPT

● Also called Revenue Recognition Concept

● When is revenue recognized?
● Sale should be recognized at the point, when the property
in the goods is passed onto the buyer and he becomes
legally liable to pay.
● Other incomes are recognized when they accrue.
● Any change in the value of an asset is to be recorded only
when the business realizes it
REALIZATION CONCEPT

● Mr. A places an order with Mr. B for the supply of certain

goods, which are yet to be manufactured.
● On receipt of the order, Mr. B purchases raw materials,
employs workers, produces the goods and delivers the
finished goods to Mr. A.
● Mr. A makes the payment on receipt of the goods.
● WHEN HAS THE SALE BEEN MADE?
REALIZATION CONCEPT

● WHEN HAS THE SALE BEEN MADE?

● The sale will be presumed to have been made not at the
time of receipt of the order for the goods, but at the time
when the goods are delivered to Mr. A
REALIZATION CONCEPT

● A business invested in the shares of a company for ₹

1000 at the beginning of a financial year. End of the year,
the share price increased to ₹ 1900.
● Should the profit of ₹900 be included in the books of
account?
● No, it is a notional profit and not the actual profit. It has
not been realized.
OBJECTIVITY CONCEPT

● Accounting data and information should be verifiable and

free from bias
● Example, for fixed assets, amount can be verified by the
purchase bill.
● In some areas like estimation of bad and doubtful debts,
such estimation should be on a reasonable basis and free
from bias.
CONSERVATISM/PRUDENCE

● “Anticipate no profits but provide for all possible

losses”
● All possible future losses should be provided and
recorded but all future profit should be ignored.
● It is a policy of playing safe.
● Provisions is made for all losses even though the
amount cannot be determined with certainty
● Ex.: Inventory is valued at cost or market price
whichever is less, Provision for bad & doubtful
debts.
CONSERVATISM

● Drawbacks
○ If this convention is followed then it is possible
that the stock of one accounting year is valued
on cost and other year at market value(net
realizable value)
○ When excessive provision is made for doubtful
debts or provision then it leads to creation of
secret reserves
○ Estimation of future losses is a subjective
judgment
CONSISTENCY

● Accounting policies should remain unchanged from one

period to another .
● E.g. Depreciation methods, Inventory Valuation.
● This facilitates both inter-firm and intra firm comparison
● No inconsistency but may seem inconsistent -

○ In case of inventory valuation, they are to be valued at

cost or market price whichever is lower. If it is valued at
cost price in one year and market price in another year
there is no inconsistency here.
FULL DISCLOSURE

● The financial statements should act as a means of

conveying information and not as means of
concealing information.
● Therefore, financial statements must disclose, truly
and fairly all the information

○ Which they purport to represent

○ Which are of material interest to all users

Example
● A company receives a notice from the Income Tax
Department to pay ₹50 lakhs of taxes.
● Is this a financial transaction and will this be recorded in
the books of accounts?
● NO, though it is expressed in monetary terms, it is not
recorded in the books. It is only a notice.
● But it is an important information which bankers,
shareholders and other stakeholders should know.
● Yes it will be disclosed under “Notes to Accounts”
 FULL DISCLOSURE

● It is due to this principle that the Companies Act, 2013

requires that the P&L a/c and Balance Sheet of a company
must be given in a prescribed form.
● Different notes such as notes about contingent liabilities,
market value of investments etc. are annexed with the
financial statement, which do not find place in the
accounting, according to the convention of full disclosure.
MATERIALITY

● Exception to the Full Disclosure principle which

requires all facts, necessary to ensure that the financial
statements are not misleading, must be disclosed.
● This principle says that only material items are required
to be disclosed in the financial statements and the
items which are immaterial to the users of accounts
may not be disclosed.
 MATERIALITY

● What is the meaning of Material Information?

● Information which is material for one person may be immaterial
from the viewpoint of another person
● This is a subjective term. It is on the judgment, common sense
and discretion of the accountant that which item is material &
which is not.
● Materiality also depends not only on the amount of the item but
also the size of the business, nature & level of information, level
of the person etc.
MATERIALITY

● Any information, misstatement of which may change the

decision of the users of financial statements, shall be
deemed to be the material information and should be
properly disclosed in the financial statements.
● Items having an insignificant effect to the user need not
to be disclosed.
● Information is material if its omission or mis-statement
could influence the economic decisions of users taken
based on the financial statement.
 Example of MATERIALITY

● Stationery purchased by the business though not used fully in the

accounting year purchased is still shown as expense.
● Depreciation on small items like crockery, books, calculators is
taken as 100% in the year of purchase. Though used by the
business for more than one year. Though books and calculators
are assets they are very small to be shown in the balance sheet.
FUNDAMENTAL ACCOUNTING ASSUMPTIONS
Fundamental Accounting
Assumptions

1. GOING CONCERN
2. CONSISTENCY
3. ACCRUAL

● If these 3 fundamental accounting assumptions are

followed in the financial statements, specific disclosure
is not required.
● If not followed, the fact should be disclosed
 ACCOUNTING POLICIES

● A fixed asset should be charged depreciation – This is an

accounting principle
● Which method of depreciation is to be charged – This is
an accounting policy
● Change in policy is permitted,

○ if required by statute or

○ change would result in more appropriate presentation

of the financial statements.
 TEST YOUR
KNOWLEDGE
 TRUE OR FALSE

Entity concept means that the enterprise is liable to the

owner for the capital investment made by the owner

TRUE
 ANSWER THE FOLLOWING

Which of the following is not classified as a fundamental

accounting assumption
Consistency, Business Entity, Going Concern

Business Entity
 ANSWER THE FOLLOWING

KG & Co. follows the written down value method of

depreciating machinery year after year. Which principle is
being followed?

Consistency
 ANSWER THE FOLLOWING

A businessman purchased goods for ₹25,00,000 and sold 80% of

the goods during the accounting year ended 31 March 2022. the
market value of the remaining goods was ₹400,000. He valued the
inventory at cost. Which principle did he violate?

Conservatism/
Prudence
 ANSWER THE FOLLOWING

The determination of expenses for an accounting period is

based on which principle?

Matching
 TRUE OR FALSE

Accrual concept means recognition of revenues as it is

earned and of costs as they are paid.

FALSE
 ANSWER THE FOLLOWING

Economic life of an enterprise is split into periodic interval

to measure its performance as per which concept?

Periodicity
 ANSWER THE FOLLOWING

Assets are classified into current assets and fixed assets

according to which principle?

Going Concern
 ANSWER THE FOLLOWING

The financial statements should act as means of conveying

and not concealing. Which basic accounting principle is
being talked about?

Full Disclosure
 ANSWER THE FOLLOWING

The expenses and incomes pertaining to full trading period are

taken to the profit & loss account of a business, irrespective of
their payment or receipt. This is in recognition of which
principle?

Accrual
Concept
 ANSWER THE FOLLOWING

Cost of the machinery purchased on 1.4.2021 ₹10 lakhs

Installation charges ₹1 lakh
Market value as on 31.3.2022 ₹12 lakhs
While finalizing the annual accounts, the company valued the machinery
at ₹12 lakhs. Is this right?

Violated the Cost Concept