Accounting concepts and conventions

Accounting Concepts and Conventions

Introduction

Concepts are essential ideas that permit

the identification and classification of

phenomena or other ideas

A concept must state all that the given

class includes and all that it excludes

Formed primarily by observation and

established through agreement

• The American Institute of Certified Public Accountants have defined the accounting principle as, “a general law or rule adopted or professed as a guide to action; a settled ground or basis of conduct or practice”.

• It may be noted that the definition describes the accounting principle as a general law or rule that is to be used as a guide to action.

• “Rules governing the foundation of accounting actions and the principles derived from them have arisen from common experiences, historical precedent, statements by individuals and professional bodies and regulation of governmental agencies”.

• Accounting principles, rules of conduct and action are described by various terms such as concepts, conventions, doctrines, tenets, assumptions, axioms, postulates, etc

• The term “concept” is used to connote accounting postulates i.e. necessary assumptions or conditions upon which accounting is based.

• The term convention is used to signify customs or traditions as a guide to the preparation of accounting statements.

ACCOUNTING CONCEPTS

Business Entity the entity is separate and distinct from the owners and the entity

is liable to the ownerHence, in a limited liability company, the enterprise is liable to

the owner (shareholder) based on the proportion of the capital investment (share capital) made by the latter

Going Concernentities have a life of infinite duration, unless facts are known

that indicate otherwise the basis of valuation of resources is influenced more by their

future utility to the business entity than by their current market valuation

• Money Measurement Concept

– Accounting records only those transactions which can be expressed in monetary terms.

– The importance of this concept is that money provides a common denomination by means of which heterogeneous facts about a business enterprise can be expressed and measured in a much better way.

Matching– Determining the profits after charging the

expenses of a period with the revenues earned in the same period

Realization– Determines the point of time when revenue

and hence returns (or profits) can be recognized objectively, unbiased, and with certainty.

• Cost Concept– All transactions are expressed in terms of

money, i.e. money is considered the common unit of measurement. The common economic value of assets and liabilities is expressed in monetary terms rather than in terms of any other physical dimension.

• Dual Aspect– This is the basic concept of accounting.

According to this concept every business transaction has a dual effect. For example, if A starts a business with a capital of Rs 1 lakh, there are two aspects of the transactions.

• On the one hand, the business has an asset of Rs 1 lakh.

• On the Other hand, business has to pay Rs 1 lakh to the owner.

• The properties owned by a business enterprise are referred to as assets and the rights or claims to the various parties against the assets are referred to as equities.

• The relationship between the two may be expressed in the form of an equation as follows:-

Liabilities = Assets

Liabilities may be subdivided into two principal types: the rights of creditors and the rights of owners. The rights of creditors represent debts of the business and are called liabilities. The rights of the owners are called capital. Expansion of the equation to give recognition to the two types of equities results in the following which is known as the accounting equation:

Liabilities + Capital = Assets

• It is customary to place `liabilities’ before `capital’ because creditors have priority in the repayment of their claims as compared to that of owners.

• Sometimes greater emphasis is given to the residual claim of the owners by transferring liabilities to the other side of the equation as:

Capital = Assets – Liabilities

All business transactions, however simple or complex they are, result in a change in the three basic elements of the equation.

• This is well explained with the help of the following series of examples

(i) Mr. A commenced business with a capital of Rs.3,000:

The result of this transaction is that the business, being a separate entity, gets cash-asset of Rs.30,000 and has to pay to Mr. Rs.30,000 his capital. This transaction can be expressed in the form of the equation as follows:

Capital = Assets

(A ) (Cash)

30,000 30,000

(ii) Purchased furniture for Rs.5,000: • The effect of this transaction is that cash is reduced by

Rs.5,000 and a new asset viz. furniture worth Rs.5,000 comes in thereby rendering no change in the total assets of the business.

• The equation after this transaction will be:

Capital = Assets

A Cash + Furniture

30,000 25,000+ 5,000

(iii) Borrowed Rs.20,000 from Mr. G • As a result of this transaction both the sides of the

equation increase by Rs.20,000; cash balance is increased and a liability to Mr.G is created.

• The equation will appear as follows:

Liabilities + Capital = Assets

Creditors (G) + A Cash + Furniture

20,000 +30,000 45,000 + 5,000

(iv) Purchased goods for cash Rs.30,000.

This transaction does not affect the liabilities side total nor the asset side total. Only the composition of the total assets changes i.e. cash is reduced by Rs.30,000 and a new asset viz. stock worth Rs.30,000 comes in.

The equation after this transaction will be as follows:-

Liabilities + Capital = Asset

Creditors(G) + A Cash + Stock + Furniture

20,000+ 30,000 15,000 +30,000+ 5,000

• Accounting Period Concept– According to this concept, the life of business

is divided into appropriate segments for studying the results shown by the business after each segment.

– This is because the life of business is considered indefinite and it is necessary to know the business situation after a appropriates interval.

Accounting Conventions

• Conservatism

• Full disclosure

• Consistency

• Materiality

Basis of Preparing Accounting

• Cash Basis of Accounting • Accrual Basis of Accounting

Analyze source documents.

Journalize transactions in the general journal.

Post entries to the accounts in the general ledger.

Prepare financial statements.

Prepare a trial balance.

Steps in The Accounting Cycle

THE ACCOUNTING PROCESS

• During the accounting period the accountant records transactions as and when they occur.

• At the end of each accounting period the accountant summarises the information recorded and prepares the Trial Balance to ensure that the double entry system has been maintained.

Thus the accounting process consists of three major parts:

(i) the recording of business transactions during that period;

(ii) the summarizing of information at the end of the period, and

(iii) the reporting and interpreting of the summary information

• The transactions that takes place in a business enterprise during a specific period may effect increases and decreases in assets, liabilities, capital, revenue and expense items.

• To make upto-date information available when needed and to be able to prepare timely periodic financial statements, it is necessary to maintain a separate record for each item.

• An account is a statement wherein information relating to an item or a group of similar items are accumulated. The simplest form of an account has three parts:– a title which gives the name of the item recorded in

the account– a space for recording increases in the amount of the

item, and– a space for recording decreases in the amount of the

item. This form of an account is known as a `T’ account because of its similarity to letter T.

DEBIT CREDIT

• The left-hand side of any account is called the debit side and the right-hand side is called the credit side.

• Amounts entered on the left hand side of an account, regardless of the title of the account are called debits and the amounts entered on the right hand side of an account are called credits.

• To debit (Dr) an account means to make an entry on the left-hand side of an account and to credit (Cr) an account means to make an entry on the right-hand side.

• The words debit and credit have no other meaning in accounting, though in common parlance, debit has a negative connotation, while credit has a positive connotation.

• Double entry system of recording business transactions is universally followed. In this system for each transaction the debit amount must equal the credit amount.

Debit Credit

Account Name

Ledger AccountT-Account Format

The T-Account

Increases to the T-account are

recorded on one side of the T-account, and

decreases are recorded on the

other side.

Debit Credit

Account Name

The T-Account

The side which increases and the side which decreases is

determined by the type of account.

Debit Credit

Account Name

• Tools used for recording transactions– Debit (DR)– Credit (CR)

• Debit refers to the LEFTLEFT and Credit to the RIGHTRIGHT side of the T-Account

Account Name

LEFT RIGHT

DEBIT SIDE

CREDIT SIDE

What Are Debits and Credits?

Rules of Debit and Credit• Transactions in accounts are recorded on the

basis of rules of debit and credit. For this purpose business transactions can be classified into three categories:-– Transactions relating to persons– Transactions relating to properties and assets– Transactions relating to income and expenses

On this basis, it becomes necessary for business to keep account of:Each person with whom it deals – PERSONAL ACCOUNTSEach property or asset which the business owns- REAL

ACCOUNTSEach item of income or expense- NOMINAL ACCOUNTS

PERSONAL ACCOUNTS

• Natural Personal Accounts

• Artificial Personal Accounts

• Representative Personal Accounts

Rule:

DEBIT THE RECIVER

CREDIT THE GIVER

Example

• Cash paid to Ramesh– Since rule of Personal Account is DEBIT THE

RECEIVER. In this example, Ramesh is Receiver, so his account will be debited.

• Cash Received from Mr. G– Since rule of personal account is CREDIT THE

GIVER, Mr. G account will be credited.

REAL ACCOUNTS

• Accounts that belongs to assets, property ad equipments are called Real accounts.– Tangible Real Account– Intangible Real Account

• RuleDEBIT WHAT COMES IN CREDIT WHAT GOES OUT

Example

• Machine purchased for cash– In this transaction, there are two accounts

Machine and Cash both are assets .– By applying rule of Real account “ Debit What

comes in”, Credit What goes out”– In this transaction Machine is coming in the

Business, so Machine account will be debited and Cash is going out of business, thus Cash Account will be credit with the rule that Credit What Goes Out.

Nominal Accounts• Nominal account include accounts of all

expenses, losses, income and gains.

• Rent, lighting, insurance, dividend, salary are example of nominal Account.

Rule– DEBIT ALL EXPENSES AND LOSSES– CREDIT ALL INCOME AND GAINS

• Important point to note here is that both Real and Nominal Accounts come in the category of Impersonal Account accounts. When any prefix or suffix is added to a Nominal Account, it becomes a Personal Account

Few examples

NOMINAL ACCOUNT PERSONAL ACCOUNT

Rent Account Rent Prepaid account, Outstanding rent account

Interest Account Outstanding interest account, Interest received in

advance account, Prepaid interest account

Salary Account Outstanding salaries account, Prepaid salaries account

Insurance account Outstanding insurance account, Prepared insurance

account

Commission account Outstanding commission account, prepaid commission

account

Class ExerciseFrom the following transactions identify the nature of account and also state which account should be debited and which should be credited:-

• Rent paid• Interest Received• Paid to Suresh• Lighting• Dividend received• Telephone charges paid• Machinery sold• Furniture purchased• Goods purchased• Goods Sold

Balance Sheet Model

A = L + C

AA = LL + CC

Debits and credits affect the Balance Sheet Model as follows:

Debits and credits affect the Balance Sheet Model as follows:

ASSETSASSETS

Debit for Increase

Credit for Decrease

CapitalCapital

Debit for Decrease

Credit for Increase

LIABILITIESLIABILITIES

Debit for Decrease

Credit for Increase

Balance Sheet Model

“A L O R E” AcronymParticular Debit Credit

A (ssets) + -

L (iabilities) - +

O (wners' equity) - +

R (evenues) - +

E (xpenses) + -

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Recording TransactionsRecording Transactions

Each transaction always affects at least two different accounts. One account has a debit effect. The second account has a credit effect.

This methodology was named “double entry” accounting by whom?

F.L. Pacioli

Initially, all transactions are recorded in the General General JournalJournal.

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General Journal PageGeneral Journal Page

GENERAL JOURNALPage:

Date Description PR Debit Credit

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Journal EntriesJournal EntriesExample 1Example 1

On January 1, 2013, ABC Company started business with a cash of Rs

INR1,00,000.

Prepare the appropriate general journal entry for the above transaction.

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Journal Entries Journal Entries Solution 1Solution 1

Two accounts are affected: Cash is increased by Rs 1,00,000. ABC owe Rs 1,00,00 to owner and this

become capital.

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Two accounts are affected: Cash is increased by Rs 1,00,000. Capital is created by Rs 1,00,000.

Description PR Debit

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Journal Entries Journal Entries Example 2Example 2

On January 15, 2013, ABC Company purchases a motor vehicle for Rs19,500 cash.

Prepare the appropriate journal entry for the above transaction.

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Two accounts are affected:

Vehicle is increased by Rs19,500. Cash is decreased by Rs19,500.

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Two accounts are affected: Trucks is increased by Rs19,500. Cash is decreased by Rs19,500.

GENERAL JOURNALPage: 1

Date Description PR Debit Credit

15-JanMotor Car 150 19,500 Cash 100 19,500

(Being purchase of truck)

Accounting concepts and conventions

Business

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