1. Accounting Concepts & Rules In this lesson we study different concepts used in accounting which help us make correct accounts.

2. 1. Money Measurement concept – This means that all information shown in the accounts of a business is in form of money. In other words, all assets and liabilities of a business are shown in money terms. Money serves as a common measurement tool and it is easier than stating that the business has 2 buildings, 6 machines, 30,000 kilos of raw-material etc. But this also has a disadvantage as important information relating to a business that cannot be translated into monetary language is not recorded in the accounts of the business. For example, information like the reputation of the business in the market the experience of the management of the business the relations that the business has with political leaders,etc. are important information that is not found in the financial accounts of a business.

3. 2. Business entity concept ; An entity is an organization for which accounting records are prepared. This concept means that the accounts of a business shall only record the events relating to the business and shall not record the personal events of the owners (that do not relate to this business). For example, if the owner of the business provides capital to the business, this event shall be recorded in the book of the firm as it relates to the business. But when the owner buys a house from his personal funds this transaction shall not be recorded in the books of the business. This concept helps in maintaining the clarity of the business position as separate from the owners financial position. This can help people interested in financing the business.

4. 3. Going concern concept : Accounting theory assumes that the business shall continue for a long period of time in the future. This means that accountants do not calculate the value of assets of the business daily and the assets appear in the accounts at the cost at which they were purchased. The accountants shall calculate the market value (resale value) of the assets of the business when : they are selling the asset they are closing the whole business.

5. 4. The Cost concept : All assets of a business are recorded at the cost at which they were purchased. This is called the book value (or historical cost) of the assets. For example, if a company purchases a machine for 20,000 AFs it will be shown at the same price and not at the amount for which it can be sold in the market today. This means accounting records are HISTORICAL in nature. Of course, the book value of assets is decreased by the estimated fall in their usable life. This process is called charging depreciation.

6. 5. The Dual-aspect concept – Every accounting entry affects at least 2 accounts. This is called the dual-aspect concept of accounting. Another meaning of this concept is that all assets of the business are either provided from the funds of the owner or from the funds of the creditors. This means, ASSETS = OWNER’S EQUITY + LIABILITIES This is the basic accounting equation.

7. 6. The Accounting period concept : Every business follows a financial year of 12 months (= 1 year) and prepares it final accounts (or financial statements) at the end of this period. A business should prepare final accounts of every because ; it is easy to prepare accounts for 1 year management needs to know the profit (or loss) they made this year Government needs tax payments from the business

8. 7. The Conservatism concept : This concept says the business should : book revenues only when they are sure they have earned it book expenses as soon as they think they could happen For example, a business should recognize income when it has sent the goods to the customer and he has received them. Also, if a machine of the business is stolen, the accountant should immediately book the expense and not wait because they might find the machine.

9. 8. The Realization concept : This means the business should : only book the amount at which the sales were actually made, and and book the sales when the goods have been delivered even if the customer has not paid cash For example, the business sold goods for $1,00,000 on credit. They were only able to recover $70,000 from their customers, The rest amount was lost as bad- debts (= customer could not pay). So the business should only show a net- revenue of $70,000. Also, as soon as the goods were provided the business would credit its sales account and debit the customer’s account. The amount lost due to non-payment of money by the customer is called bad-debts. For example, goods sold to customer for $1000 and after some days he only pays $900. So bad-debts are $100. See next page to understand the journal entries.

10. Customer’s a/c Dr. Sales a/c Recording of sales made to customer 1000 Cash a/c Dr. Bad debt expense a/c Dr. Customer’s a/c Recording of receipt of cash and bad debts 900 100 1000 A journal entry where 2 or more accounts are debited or credited at the same time is called a Compound Journal Entry.

11. 9. The Matching concept : This concept needs that the accountant matches the revenue with the expenses made to earn that revenue. For example, a business purchased raw-materials worth $2000 and total processing expenses on these materials are $500. Then the business sold the goods for $4000. So the accountant should deduct the total expenses from the revenue to get the income (profit) made by the business, that is: purchases = $2000, plus processing expenses = $500 TOTAL EXPENSES= $2500 PROFIT = SALES – TOTAL EXPENSES = $4000 - $2500 = $1500 So the matching-concept helps us match the expenses with the revenue earned to get the correct income amount.

12. 9. The Consistency concept – This concept means that the accountant should use the same method for one type of accounting calculation every year. For example, we have different methods to calculate the value of closing inventory. But once a method has been chosen, the business-accountant shall use this method every year. The method can only be change if it is very much necessary. And if the method is changed it should be informed to all people reading the accounts and financial statements of the business.

13. 10. The Materiality concept – The concept means that the accountant should not try to identify, record and report very small matters and events. For example, the accounting department misplaces a pen somewhere and cannot find it. Now the accountant should not write an entry in to the accounts regarding the loss suffered due to this pen. Because recording such small events would : make the work of the accountant very big and nobody needs such information In practical situations such small loses / expenses are included in a general account called ‘Other Expenses’ for the department.

14. 10. The Accrual accounting versus The Cash accounting- Accrual accounting: recognizes revenues as the goods are delivered to he customer recognizes expenses as they happen in generation of revenues For example, a shop sells goods to Ali and he promises to repay in 30 days. The accountant will not wait 30 days to recognize the revenue. He will book it as soon as the goods are given to customer. Similarly, the business considers only those expenses which relate to the revenues for the period. For example, cost of only those raw-materials is treated as expense which have been used in the goods sold to the customers. Others are treated as inventory (= current asset) of the business.

15. In Cash accounting – Revenues are recognized only when cash is received Expenses are recognized when cash is spent. For example, a business using cash-based accounting shall not recognize revenue when the customer takes goods and promises to pay later. In fact, they would not even make a general entry at that time and will wait till the time the customer pays cash to the business. Similarly, expenses are recognized only when cash is paid. For example, the business buys some raw-material, the whole of the cost of the raw-material is expensed at that time. They will not wait for the time when raw- material is processed and sold to customer. Cash-based accounting could give us mismatched accounts. For example, it could show us huge profits in one year and huge losses in other years. Therefore, only small shop-owners use cash-based accounting. Big companies always use accrual accounting systems.