Depreciation is referred to as the reduction in the cost of a fixed asset in sequential order, due to wear and tear until the asset becomes obsolete. Following are some of ...
Accounting Concepts Accounting concepts are the rules, assumptions and methods generally accepted by accountants in the preparation and presentation of financial statements of an entity. These concepts have been developed by the accounting profession for a long period. These concepts constitute theRead more
Accounting Concepts
Accounting concepts are the rules, assumptions and methods generally accepted by accountants in the preparation and presentation of financial statements of an entity. These concepts have been developed by the accounting profession for a long period.
These concepts constitute the foundation of accounting and one has to be aware of them to maintain correct and uniform financial statements.
I have listed and briefly explained the following accounting concepts.
- Entity Concept
- Money Measurement concept
- Going on concern
- Periodicity concept
- Accrual concept
- Cost concept
- Realisation concept
- Matching concept
- Dual aspect concept
- Conservatism concept
- Materiality concept
- Consistency concept
#1 Entity Concept
As per this concept, the business and its owner are separate entities from the point of view of accounting. It means the assets and liabilities of the business and owner are not the same.
However, in the eyes of law, the business and its owner may be a single entity.
#2 Money measurement concept
This concept states that the transaction which can be measured in terms of money shall only be recorded in the books of accounts.
Any transaction which cannot be measured in terms of money shall not be recorded.
#3 Going concern concept
Going concern concept is also a fundamental accounting assumption. It assumes that an enterprise will continue to be in business for the foreseeable future.
It means its accounts will also be prepared to take such assumptions that the business will continue in future.
#4 Periodicity concept
The periodicity concept states an entity needs to carry out accounting for a definite period, generally for a year known as the accounting period. The period can also be half-year or a quarter.
The cycle of accounting restarts at the start of every accounting period.
#5 Accrual concept
The word accrual comes from the word
As per the accrual concept, the expense and incomes are recorded in the books of accounts in the period in which they are expected to incur whether payment in cash is made or cash is received or not.
For example, the salary to be paid by a business is to be recorded as an expense in the year in which it is expected or liable to be paid.
#6 Cost concept
It is concerned with the purchase of the assets of a business. As per the cost concept, a business shall record any asset in its books at the acquisition cost or purchase cost.
#7 Realisation concept
This concept is concerned with the sale of assets. A business shall record the sale of the assets in its books only at the realised cost.
#8 Matching concept
As per this concept, revenue earned during a period should be matched with the expenses incurred in that period. In short, an entity needs to record the income and the expenses of the same period.
#9 Dual concept
This concept is the foundation of double-entry accounting. Dual concepts state that every transaction has two effects, debit and credit.
One or more accounts may be debited and other one or more accounts are credited so that the total amount of debit and credit equals.
#10 Conservatism concept
The conservatism concept states that an entity has to account for expected losses and expenses but not for future expected profits and gains.
#11 Materiality concept
As per this concept, only those items which are material should be shown in the financial statements of an entity. It says that items which are immaterial or insignificant in terms of value or importance to stakeholders can be ignored.
#12 Consistency concept
It says that an entity should follow consistent accounting policies every accounting period so that a comparison can be made among the financial statements of different accounting periods.
GAAP
Generally Accepted Accounting Principles or GAAP is a combination of authoritative standards which are set by policy boards and commonly accepted methods of recording and presenting accounting information.
GAAP or US GAAP is formulated by the Financial Accounting Standards Board or FASB and almost state in the USA is compliant with GAAP.
The main goal of the GAAP is to ensure that the financial statements of an entity are complete, consistent and comparable.
It can be said accounting concepts are part of GAAP.
Ten key principles of GAAP
#1 Principle of regularity
It states that an accountant has to comply with GAAP regulations as a standard.
#2 Principle of Consistency
Accountants should be committed to applying the same set of standards throughout the accounting and reporting process, from one period to another. This is to be done to ensure comparability of financial statements between periods.
Also, the accountants have to fully disclose and explain the reason behind any changed or updated standards in the note of accounts of financial statements.
#3 Principle of sincerity
It states that the accountant should strive to provide an accurate and unbiased view of the financial situation of a company.
#4 Principle of Permanence of Methods
As per this principle, a company should be consistent in procedures used in financial statements so that it allows the comparison of the company’s financial information.
#5 Principle of Non-Compensation
Both negative and positive should be reported with full transparency. There should be no debt compensation i.e. debt should not be set off against any asset or expenses against revenue.
#6 Principle of Prudence
It states that financial data presentation should be fact-based. This principle is similar to the conservatism concept.
#7 Principle of Continuity
This is as same the going concern concept. It states that while valuing assets, it should assume that the business will continue for the foreseeable future.
#8 Principle of Periodicity
It is the same as the matching concept. It states that the revenue and expenses should be recorded in the period in which they occur.
#9 Principle of Materiality
Accountants should disclose all the financial information that is significant in the decision-making of the users of financial statements.
#10 Principle of Utmost Good Faith
It states that all parties to a transaction should act honestly and not mislead or hide crucial information from one another.
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The main objective of depreciation is to calculate net profit. Depreciation is an expense allowed on the fixed assets of an entity to provide for the cost of benefit utilized by the entity in that particular year. Since the such assets are used for more than one financial year, profits for the furthRead more
Depreciation is an expense allowed on the fixed assets of an entity to provide for the cost of benefit utilized by the entity in that particular year. Since the such assets are used for more than one financial year, profits for the further years would be misstated if such depreciation expense is not provided for.
Further, depreciation in no way shows previous profits or satisfies the tax department and a reduction in tax is secondary since it will only be allowed if charged in the profit & loss account. Thus, B is the correct answer.
2. Depreciation is generated due to wear and tear.
Depreciation is provided for to compensate for the wear and tear of the asset while being used by the entity. Depreciation is not generated due to increase in the value of liability, decrease in capital or decrease in the value of assets. Rather the vice versa is true, that is an increase in liability, decrease in capital and decrease in asset is created due to depreciation.
Thus, C is the correct answer.
3. The purpose of making a provision for depreciation in the accounts is to charge the cost of fixed assets against profits.
Fixed assets are long term assets with useful life of more than one accounting year and therefore the full cost of such assets are not provided for in the year of purchase rather a fixed portion is charged every year in the profit and loss account.
Thus, A is correct and others are incorrect.
4. According to the straight line method of depreciation, the depreciation remains constant.
In the straight line method of depreciation, depreciation is calculated on the historical or purchase cost of the asset and the same amount is charged every year till the useful value of the asset, thus depreciation remains constant.
Also, depreciation decreases each year in case of written down value method but depreciation can never increase. Thus, A is the correct answer.
5. Total amount of depreciation of an asset cannot exceed its depreciable value.
The depreciable value is the purchase cost of the asset less the scrap value. The total amount of depreciation can never exceed the depreciable value since depreciation is allowed on an asset till its useful life at a certain percentage. Even when the value of the asset becomes nil, no further depreciation would be charged and total depreciation would be equal to depreciable value but obviously cannot be more.
Thus, A is the correct answer and other are wrong.
6. According to fixed installment method, the depreciation is calculated on original cost.
In the fixed installment method, also known as the straight line method, depreciation is calculated on the basis of the original or purchase cost of the asset using the formula-
Depreciation = (Original cost – Scrap value)/Useful life of asset
Thus, B is the correct answer.
7. Salvage value means estimated disposal value.
Salvage value is the value of the asset that can be realized by the entity on its sale after the useful life of the asset has been exhausted and is now obsolete for the entity.
Salvage value is not definite but an estimation. Salvage value can be positive or nil but not negative. Thus, D is the correct option.
8. Depreciation is calculated under diminishing balance method, based on book value.
Under the diminishing value method, the depreciation is calculated at a certain percentage of the book value of the asset which is calculated after providing for depreciation in the previous year.
Depreciation cannot be calculated on scrap value since it is the disposable value of the asset and depreciation on original value is calculated under straight line method. Thus, B is the correct option.
9. Depreciation amount charged on a machinery will be debited to depreciation account.
Depreciation is an expense and depreciation account will be debited since depreciation is a nominal account, as per traditional method, and all expenses are debited. Also, as per modern rules of accounting, increase in expenses are debited.
When depreciation is charged there is a decrease in the value of assets therefore machinery account will be credit also depreciation cannot be classified under repair account or cash account heads. Thus, C is the correct option.
10. In accounting, becoming out of date or obsolete is known as obsolescence.
Amortization means decrease in the value of intangible assets of an entity. Depletion means exhaustion of existing wasting assets such as coal mines. Physical deterioration means fall in value of asset due to physical damage to the asset. Therefore, the correct answer is Obsolescence.
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