Accounting Concepts 1.2

8/3/2019 Accounting Concepts 1.2

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Accounting

Principles

By Dilshad D. Jalnawalla


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Accounting Principles are a body of doctrinescommonly associated with the theory andprocedures of accounting, serving as anexplanation of current practices and as a guide

for selection of conventions or procedures wherealternatives exist.

These assumptions are rules of the game andthey have been developed from common

accounting practices.


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A generally accepted set of rules can provideuniformity in the accounting system, theaccounting procedure and presentation ofaccounting results.

These assumptions help accounting statementsto become comparable, leading to betteranalysis and comparison of performances.


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ACCOUNTING

CONCEPTS


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The term concepts includes those basicassumptions or conditions upon which the

science of accounting is based.1. Business Entity Concept

2. Going Concern Concept

3. Cost Concept4. Money Measurement Concept

5. Duality Concept

6. Accounting Period Concept7. Matching Concept

8. Realisation Concept


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Business Entity Concept

A business entity is an organization of personsto accomplish an economic goal. An entity isdefined as those undertakings under the controlof a single management. This may include asole-proprietor, a partnership firm, a company ora non- profit making organization.

This business entity is considered separate and

distinct from the owners of the enterprise.


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For Example:- When an owner Mr.X startsa business, styled X & Co., he bringscapital into the business, the business in

turn is deemed to owe the capital to theowner. This means the accounts are to beprepared only from the point of view of

X & Co.- as if it was a different personfrom the owner.


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This concept is applied to all forms ofbusiness organizations for the followingreasons

a) Its a solution to the problem of separating thebusiness transactions from the personaltransactions of the owner.

b) To ascertain the return on capital employedenabling us to record how successful orotherwise the business has been.

c) To ensure proper use of funds provided by theowner.

d) To hold title to property in the name of the firm.e) To enter into transactions with outsiders in thename of the firm.


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Going Concern Concept

Accounting is based on the concept that abusiness unit will be operating for long.

The accounting system provides a

continuous record of the performance ofthe business throughout its existence. Thisconcept assumes that the business unitwill continue operating under the sameeconomic conditions and in the samegeneral environment.


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This concept relates to the future which is, bydefinition, uncertain. Therefore, many factorscan be used to determine whether a business

unit is a going concern. They include thefollowing:a) Liquidity:Should have sufficient liquid assets to pay its

liabilities. Various ratios can be applied to ascertain the liquidity ofthe business unit.

b) Capital Structure:It must have a sound capital structure toovercome any short-term or long term difficulties. CapitalStructure of a business unit is influenced by several factors suchas cost of various sources of capital, dividend policy, the risk ofinsolvency, stability of earnings, and the like.

c) Market:Should have continuing demand for the goods it dealsin and/or the services it supplies.d) Management Ability:Should be managed efficiently and

effectively to produce a competitive product and to see that theobjectives of the enterprise are achieved.


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Going Concern Concept presumes thatthe enterprise will continue in operationlong enough to charge against income, the

costs which have been deferred under theaccrual concept, to pay liabilities whenthey become due and to meet the

contractual commitments.


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Cost Concept

Historical cost refers to the cost at the timeof acquisition.

In accounting all transactions are generallyrecorded at cost and not at market value,this cost becomes the basis forsubsequent accounting for that asset.

This is because, this figure can normallybe ascertained beyond doubt.


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For Example: If a business buys a plot ofland for Rs.2 lakh, the asset would berecorded in the books at Rs.2 lakh even if

its market value at that time happens to beRs.2.5 lakhs. It would continue to beshown in the balance sheet at Rs.2 lakh,

even if later the market value of the landrises to say Rs.5 lakhs.


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In absence of this concept the figures would

have depended on the subjective views of aperson.

But on account of continued inflationarytendencies the preparation of financial

statements on the basis of historical costs hasbecome largely irrelevant for judging thefinancial position of the business.

But pragmatic consideration of the possibilitieshas always found historical cost, in spite of itsacknowledged limitations, to be superior.


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Money Measurement Concept

Money provides a uniform way to measurethe value of goods and services.

All business transactions are recorded in

terms of money because money is auseful way of converting accounting datainto a common unit.

Only those transactions which can bemeasured in terms of money are to berecorded in the books of account.


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For Example: Purchase of an Asset canbe measured in rupee term so it is to berecorded. But retirement/ death of a

Chairman, cannot be measured inmonetary terms so it cannot be recordedin accounts.


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There are two problems with this concept;

1. The concept assumes stability in the value of money.

2. Many factors which are of vital importance to thebusiness are outside the purview of accounting. (LikeQuality of management, growth of competition,changes in the nature of demand etc.)

Inspite of these limitations this concept isaccepted as it is not possible to employ a

better measurement scale that can be easilyunderstood by the users of accountinginformation.


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Duality or Double Entry Concept

This concept states that for everytransaction, there will be two aspects.

This concept is build around the fact thatevery time something is given, someoneelse receives it.

Assets = Owners equity + Outside liability


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For Example:

When an equipment is purchased forcash,

the new asset comes in (use of fund), andthe cash will decrease (source of fund).


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Accounting Period Concept

This concept arises from Going concernconcept.

To be able to prepare the incomestatement for a business, the period forwhich it is to be prepared must bespecified.

An accounting period may be a calendaryear or a financial year.


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Advantages

Uniformity and consistency in accountingtreatment for profit ascertainment andasset valuations.

Proper matching of periodic revenues andexpenses to achieve the objectives ofaccounting.

Comparability of financial statements ofdifferent period is facilitated.


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Matching Concept

This concept results from the accounting periodconcept.

In order to determine the profits or lossesaccrued in an accounting period, the expensesmust relate to the goods or services sold duringthe period.

The expenses incurred in the production should

be matched with the revenues realized from thesales of the goods and services.


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This concept requires proper allocation ofcosts into different accounting periods sothat relevant incomes and expenses are

matched.

The profit of an accounting period is therevenue less expenses incurred in

producing those revenues.


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Realization Concept

Revenues are recognized only when thegoods and services have been deliveredand there is certainty that the revenue will

be realized. In determining profits, credit sales are also

taken into account.

If from the past experience it is realizedthat revenue will be 95% of sales, aprovision of 5% can be created fordoubtful debts.


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Example: A places an order with B forsupply of certain goods yet to bemanufactured. On receipt of the order, Bpurchased raw material, employs workers,

produces the goods and delivers them toA. A makes the payment on receipt ofgoods. In this case the sale will bepresumed to have been made not at thetime of receipt of the order but at the timewhen goods are delivered to A.


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Exceptions

1. Hire Purchase: Ownership passes when lastinstallment is paid, but sales are presumed to

the extent of installments received andinstallments outstanding.

2. Contracts Account: Contractor is liable to payonly when the whole contract is completed asper the terms of the contract, the profit iscalculated on the basis of work certified.


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ACCOUNTING

CONVENTIONS


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The term conventions includes those customs

and traditions which guide the accountantswhile preparing the accounting statements.

1. Convention of Conservatism

2. Convention of Full Disclosure3. Convention of Consistency

4. Convention of Materiality

5. Convention of Objectivity


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Conservatism

In the initial stages of accounting, certainanticipated profits which were recorded, did notmaterialize. This resulted in less acceptability of

accounting figures by the end-users. This concept emphasizes that revenues are

recognized only when they are reasonablycertain and expenses are to be recognized as

soon as possible.

Recognise all losses and anticipate no gains


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For example: Only after a deal is finalizedand items are delivered to the client thepayment for items become due from the

client. But if we come to know that acustomer has lost his assets, we shouldimmediately either make provision for such

loss or write them off.


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Full Disclosure

All financial events which occur during aparticular financial period should fairly andcompletely be reported in the financial

statements. Full disclosure is required when alternative

policies are available, principles peculiar toparticular industry and unusual orinnovative application of accountingprinciples.


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Eg.: The firm changes its recording orreporting procedures. The user maymisinterpret the information if recording or

reporting system is modified and not fullydisclosed.


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Consistency

Accounting principles are not static orunchanging. It is possible to adopt avariety of principles and procedures for

business transactions.

Once an entity has decided on onemethod, it will treat all subsequent events

of the same character in the same fashionunless it has a sound reason to change.


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For example: If a concern is chargingdepreciation on fixed assets according todiminishing balance method (one method)

it is expected to follow the same method inthe subsequent years also.


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This is necessary for the purpose ofcomparison.

Consistency does not mean inflexibility.However, if adoption of such a techniqueresults in inflating or deflating the figuresof profit as compared to the previous

period, a note to that effect should begiven in the financial statements.


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Materiality

A brand new pencil is an asset to thebusiness unit. Whenever the pencil isused, a part of the asset is consumed.

Although the pencil is still in use at the endof the year, its original cost is soinsignificant that it would be a waste of

time to evaluate and include it in closingstock. Instead, it is written off as expensein the period it was purchased.


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All financial transactions need to berecorded in the books of accounts.However there may be transactions which

may be insignificant and are not shownseparately. They are usually clubbed withothers.

There is no agreement as to the exact lineseparating material events from immaterialevents.


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Eg.: While sending each debtor a statement ofhis account, complete details have to be given.However, when a statement of outstandingdebtors is prepared for sending to top

management, figures may be rounded to thenearest ten or hundred.

The companies Act also permits ignoring ofpaise while preparing financial statements.

For Tax purposes, the income has to berounded to nearest ten.


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Objectivity

The economic data supplied by financialstatements should be based on verifiableevidence and should not be biased.

Each transaction should be recordedwhich is substantiated with objectives andverifiable source documentation.

The principal ensures that capricious(unpredictable) or unsubstantiated(unconfirmed) judgments do not enter intothe financial records of the company.


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Many accounting measures are partiallysubjective because of the items beingmeasured.

Eg. Ascertainment of estimated useful lifeand scrap value of a fixed asset forcalculating depreciation.

Objectivity, therefore, cannot be fullyachieved in accounting.


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Forms of Business OrganisationForm of

organisation

Typical Size Decision

Making

Government

Regulation

Suitability

SoleProprietorship

Small SingleOwner

Completelyflexible

None SmallBusiness

Partnership Small tomediumMin 2; max 20partners

Largelyflexible butpartners maydisagree

Virtuallynone

Small, mediumbusinessProfessionalpractices

Limited Company

A. Private Small tomediumMin 2; max 50shareholders

Largelyflexible butdirectors maydisagree

CompaniesAct appliesbut is mild

Small, mediumbusiness, oftenbecause of legalrequirement orto get bank loan


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Forms of Business OrganisationForm of

organisation

Typical

Size

Decision

Making

Government

Regulation

Suitability

B. Public Limited Company

i. Not Listed Mediumto Large. Min 7

shareholders; no maxlimit

Very Rigid Directorsmay disagree

Companies Actapplies and isrigorous

Extensive filing ofdocuments, publicdisclosures.

Medium tolargebusiness

ii. Listed Large tovery largeMin 7

shareholders; no maxlimit

Very Rigid Directorsmay disagree

Companies Actapplies and isrigorous

SEBI Act appliesand is very rigorous Extensive filing ofdocuments, publicdisclosures.

Large tovery largebusiness

which requirehuge publiccapital.


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Omission of paise and showing roundfigures in financial statements is

based on -----

a. Conservatism concept

b. Consistency concept

c. Materiality concept

d. Realization concept

e. Cost concept


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Under which of the following concepts areshareholders treated as creditors for the

amount they paid on the shares theysubscribed to?

a. Cost Concept

b. Duality concept

c. Business Entity Concept

d. Going concern concept

e. Since the shareholders own thebusiness, they are not treated ascreditors.

Whi h f th f ll i t i /


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Which of the following events is/are

not recorded in the books of a

business?a. Significant monetary events after the

balance sheet date

b. Death of a chief executive of thebusiness

c. Government investigations into thepricing policies of the business

d. Both (b) and (c) above


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Recording of fixed assets at

cost ensures adherence of

a. Conservatism Conceptb. Going Concern Concept

c. Cost Concept

d. Both (a) and (b) abovee. Both (b) and (c) above


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Sales are recognized as income:

1. At the point of sale or at the performanceof a service.

2. After the expiry of the credit periodallowed to debtors.

3. After the money collected from thedebtors.


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Matching principle results from the

1. Accounting period principle

2. Duality principle3. Historical cost principle


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Accounts produced objectively will

be unbiased and hence tend to bemore

1. Relevant2. Comparable

3. Reliable


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