Accounting Concepts: Why are they necessary?
Accounting was invented to provide a fair answer to the question – how does one evaluate the performance of firm in a given specific time period?
The question was complex as business of a firm is ongoing and does not start and stop with the period start and end dates. The orders or projects at any point of time would be at various stages of maturity which means that order arrival, execution, closure, payments and revenues, can span across measurement periods. As a result there were following dilemmas.
- If purchase of raw material is made in one period, which is then converted to finished goods and sold in next period. In which period should the revenues and expenses be accounted
- Any error might give an incorrect assessment of the period performance of the firm.
- If the actual money received for an order, sold in year 1, is in year 2, when should we account the sales to provide a fair picture about performance of the firm?
- If the money to be given to a vendor, after receipt of the service and its use in delivery of end products in same period, is actually paid in the next period, when do we account for the expenses?
Improper expense accounting in above cases can lead to situations where a firm shows very high profits in one period ( period with all revenues but no expenses for the revenues) and then very low profits in next period (where all expenses are accounted without revenues). At the end we would not have any clue on how the firm performed in the period.
To solve the above problems and provide fair assessment for the period, following principles were invented
- Matching Concept
- Accrual Accounting
The matching principle indicates that the expenses should be matched with revenues. They are not recognized until the associated revenue is also recognized. For instance, wages paid to manufacturing workers are not recognized as expenses until the actual products are sold. When the products are sold, the expenses are recognized as cost of goods sold. Similarly, depreciation was invented to spread the cost of purchasing a fixed asset is spread over the period in which it is expected to generate revenue.
Accrual Concept is used to enable the implementation of matching principle. For example if a supplier supplies material in month 1 but is paid in next month and the final goods are sold in first month, then accounting of material expenses in month 2 will show an abnormal profits. Accrual concept will help account the raw material costs in month 1. Similarly revenues are recognized when they are earned or are realizable, even though cash is not received.