Basic concepts underlying financial accounting

A business firm engages in a number of economic transactions. It raises capital, invests in different kinds of assets, buys raw materials on credit or cash, transforms raw materials into finished goods by applying labor and machinery , sells finished goods on credit, collects its receivables , pays interest and taxes, depreciates its machineries, repays borrowed money, and so on.

The financial accounting model processes the economic transactions to produce a set of financial statements.

The framework of financial accounting in based on several concepts (also referred to as postulates, convention and principles) which have received widespread, though not universal, acceptance by accountants. The important concepts are briefly described here:

Entity Concept: For purposes of accounting, the business firm is regarded as a separate entity. Accounts are maintained for the entity as distinct from the persons who are connected with it. The accountant records transactions as they affect this entity and regard owners, creditors, suppliers, employees, customers and the government as parties transacting with this entity.

Money Measurement Concept: Accounting is concerned with only facts which are expressible in monetary terms. The use of a monetary yardstick provides a means by which heterogeneous elements, such as land, plant and equipment, inventories securities and goodwill may be expressed in a common denominator.

Stable Monetary Unit Concept: An implicit assumption in accounting, as it is practiced, is that the monetary unit remains stable and values recorded at the time that events occur are not changed. Put differently, changes in the purchasing power of money are not considered. This principle has been challenged and forceful arguments have been advanced for making adjustments for price level changes. Despite the great plausibility of these arguments, the practice of accounting is still based on the stable monetary unit assumption.

Going Concern Concept: According to the going concern concept, accounting is normally based on the premise that the business entity will remain a going concern for an indefinitely long period.

Cost Concept: Assets acquired by a business are generally recorded at their cost and this is used for all subsequent accounting purposes. For example depreciation is charged on the basis of the original cost. It is evident that this concept is related to the stable monetary unit concept.

Conservatism Concept: This concept modifies the cost concept in the case of current assets. It is usually stated as follows: Anticipate no profit but provide for all possible losses. In accordance with this concept current assets are generally valued at cost or market value whichever is lower.

Dual Aspect Concept: Regarded as the most distinctive and fundamental concept of accounting, the dual aspect concept provides the basis for accounting mechanics. Before explaining this concept let us define the terms “assets”, “liabilities”, and “equity”.

1. Assets are what the firm owns. The major assets of a firm are land, buildings, plant and machinery, financial securities, inventories, debtors, bank balances, and advances and loans given to others.
2. Liabilities are what the firm ‘owes’ to various parties such as lenders, suppliers, employees, government, and others. Term loans working capital advances, trade credit, wages payable and taxes payable are examples of liabilities.
3. Equity represents the residual interest of the owners in the assets of the firm. Equity is simply the differences between the assets of the firm and its liabilities.

According to the dual aspect principle, the assets of the firm are always equal to its liabilities and equity.

Assets = Liabilities + Equity

How come that the above identity always holds? To answer this question let us look at the relationship between the firm (the accounting entity) and the owners.

If the firm makes profits which are ploughed back in the business, reserves and surplus (which represent a part of equity) increase. Profit is created by the efforts of the management of a company and belongs to and retained by it increasing the reserves and surplus.

Thus, the balance in the reserves and surplus account is adjusted to ensure that the balance sheet always balances.