Question

Define the entity concept and the historical cost concept of financial accounting.

Answer 1

1. Entity Concept: As per the Entity concept business has its own distinct entity. All transactions related to the business are recorded separately distinct from Businessman’s transaction.

1. It is necessary to keep personal transaction of the businessman separate from business to ascertain the true and fair P&L of the business.
2. Without this concept it is very difficult to distinguish personal expenditures and incomes the businessman with the transactions of business.

There are number of reasons for business entity concept.

1. It is essential to know the profitability and financial position of the business.
2. All business entities will be taxed separately
3. To determine the amount of amount of payout to various owners at the time of liquidation.

2. Historical cost: Historical Cost is the purchase cost of an assets. In Historical cost method, we show the Assets in Balance sheet at Acquisition or original cost. The Fixed assets are shown in Balance sheet at Historical cost as per GAAP (Generally Accepted Accounting principles) in United States of America.

Logic behind keeping FA (Fixed Assets) in BS (Balance sheet) at HC (Historical cost) is Conservatism. We keep FA in BS at HC even if current value of the assets in significantly higher than the HC.