Chap-2dhtrh

20 ACCOUNTANCY

LEARNING OBJECTIVES

After studying this chapter, you will be able to :

comprehend the meaning of Generally Accepted Account-ing Principles (GAAP),

state and relate the basic operating guidelines used by ac-countants in the accounting process,

explain the basic assumptions;

explain the accounting principles;

explain the modifying principles.

CHAPTER 2

Theory Base of Accounting

THEORY BASE OF ACCOUNTING 21

The understanding of theseguidelines is important for both, theaccountants who prepare the financialstatements, and the users who needto use these statements. Now, we willdiscuss these assumptions andprinciples.

2.1 Basic Assumptions

Assumptions are traditions andcustoms, which have been developedover a period of time and well-accepted by the profession. Basicaccounting assumptions provide afoundation for recording the tran-sactions and preparing the financialstatements there from. There are fourbasic assumptions that areconsidered as cornerstones of thefoundation of accounting. These are:accounting entity, money measure-ment, going concern and accountingperiod which are discussed below:

We have discussed the meaning andobjectives of accounting in thepreceding chapter. It was discussedthat basic objective of accounting is toprovide information to the differentusers. This information is embodied inProfit & Loss Statement and BalanceSheet which contain terms andconcepts, having their basis in thetheoretical foundation of accounting,usually, referred to as GenerallyAccepted Accounting Principles(GAAP). The set of rules and practicesfollowed in recording transactions andpreparing financial statements areusually called Generally AcceptedAccounting Principles. GAAP providesa set of guidelines to be observed bythe accounting profession forpreparing and reporting the financialinformation. The guidelines can becategorized into basic assumptions,principles and modifying principles(figure 2.1).

Generally Accepted Accounting Principles

Assumptions Principles Modifying AccountingPrinciples Standards

Accounting Entity Duality Cost-benefit Issued by Accounting

Money Measurement Revenue Recognition Materiality Standards Board Going Concern Historical Cost Prudence (Indian And Accounting Period Matching Consistency International)

Full Disclosure Timeliness Objectivity Substance over Legal

form Industry practice

Fig. 2.1

22 ACCOUNTANCY

2.1.1 Accounting Entity Assumption

Accounting entity assumption statesthat the activities of a business entitybe kept separate from its owners andall other entities. In other words,according to this assumption businessunit is considered a distinct entity fromits owners and all other entities havingtransactions with it. For example, inthe case of proprietorship, the law doesnot make any distinction between theproprietorship firm and the proprietorin the event of firms inability to payits debts. Hence, in this situation, tomeet the deficit, law requires theproprietor to pay firms debts from his/her personal assets. But, these two aretreated as separate entities whilerecording business transactions andpreparing the financial statements.

This assumption enables theaccountant to distinguish between thetransactions of the business and those

of the owners. Consequently, thecapital brought into the business andwithdrawals from the business by theowners will also be recorded in thesame manner as that of transactionwith other entities. For example, if theowner brings in cash or any otherasset, it will result in increase in assetsof the business and capital of the firm.This capital represents firms liabilityto the owner. The expenses of theowner paid by the firm assets arerecorded as withdrawals from thebusiness. This means the profit andloss account will show the revenuesand expenses related to the businessentity only. Consequently, balancesheet will show the assets andliabilities of the business entity only.This assumption is followed in allorganizations irrespective of their form,i.e., sole proprietorship, partnership,cooperative, or company.

A manufacturing company owns different assets such as 200 sq mts of land; building with40,000 sq feet of built-up area; furniture and fittings comprising of 2 sofa sets, 2 centraltables, 10 chairs, 6 computer tables, 2 steel almirahs and electrical fittings (switches,wires, tube lights, fans, etc. ); plant and machinery capable of processing 200 units ofoutput per day; 2 cars, 1 delivery van; 5000 Kgs of raw materials, etc. Since these assetsare expressed in different units of measurement, they cannot be subjected to anyarithmetical calculation. However, all these assets must have been acquired by payingcertain amount of money (i.e., rupees). Hence, using rupee as a unit of measurement,these can be expressed as follows:

Land : Rs. 2,00,000Building : Rs. 13,70,000Furniture and Fittings : Rs. 25,000Plant and Machinery : Rs. 3,85,000Motor vehicles : Rs. 8,75,000(2 cars + 1 van)Raw Materials : Rs. 75,000Now, we can say that the total assets owned by the firm amounts to Rs.29,30,000.

Box 2.1


2.1.2 Money Measurement Assumption

This assumption requires use ofmonetary unit as a basis ofmeasurement, i.e., the currency of thecountry where the organization is toreport its operations. This implies thatthose transactions which can not bemeasured by monetary unit will notbe recorded in the books of accounts.Monetary unit is supposed to providea common yardstick to measure theassets, liabilities and equity of thebusiness. The different items,expressed in varied basis ofmeasurement, like area, volume,numbers, cannot be added togetherbecause of heterogeneity of scales ofmeasurement. But, once all these areconverted into a homogeneous unit ofmoney, they can be added together orsubjected to any arithmeticalcalculations. It also indicates thatcertain information, howsoeverimportant it may be to state the trueand fair picture of the entity, will notbe recorded in the financial accountingbooks if it can not be expressed interms of money. For example, theunion-management relations, health ofthe key manager, quality of itsmanufacturing facilities, etc. can notbe expressed in monetary value, andhence, are not recorded in books ofaccounts.

It is clear from the above thatmoney measurement assumptionmakes the accounting records clear,simple, comparable and under -standable. The acceptability of moneyas a unit of measurement is not free

from problems when we compare thefinancial statement over a period oftime or integrate the financialstatements of an entity havingoperations in more than one nation.This is to be noted that the assumptionimplies stability of measuring unit overa period of time. This may not be trueover a period of time because prices ofgoods and services may change, hence,the purchasing power (value) of moneymay undergo changes. But thesechanges are not usually recorded. Thisaffects the comparability of thefinancial statements prepared atdifferent time periods.

2.1.3 Going Concern Assumption

The financial statements are preparedassuming that the business will havean indefinite life unless there isevidence to the contrary. The businessis called going concern therebyimplying that it will remain inoperation in the foreseeable futureunless it is to be liquidated in the nearfuture. Since, this assumption believesin continuity of the business overindefinite period, it is also known ascontinuity assumption. The goingconcern assumption facilitates thatdistinction made between: (i) fixedassets and current assets, (ii) Shortterm and long term liabilities, and (iii)capital and revenue expenditure.

2.1.4 Accounting Period Assumption

We have stated in the previousparagraph that accountants assumebusiness to be in activities in theforeseeable future. Therefore, results

24 ACCOUNTANCY

of business operations cannot be trulyascertained before the closure of thebusiness operations. But this periodis too long and the users of theaccounting information cannot wait forsuch a long period of time. Hence, theaccountants make the assumption ofaccounting period (also known asperiodicity assumption). Thisassumption permits the accountant todivide the lifespan of the businessenterprise into different time periodsknown as accounting period(quarterly, half-yearly, annually) forthe purpose of preparing financialstatements. Hence, financial state-ments are prepared for an accountingperiod and results thereof are reportedon periodic basis.

This assumption requires that thedistinction be made between theexpenditure incurred and consumedin the period, and the expenditure,which is to be carried forward to thefuture period. The cut off period forreporting the financial results isusually considered to be twelvemonths. Usually the same is true fortax purpose. However, in some casesaccounting period may be more or lessthan 12 months depending on theneeds of business enterprises. Forexample, a company can prepare itsfirst financial statements for a periodof more than or less than one year.Currently, the interim reports issuedby the company, though unaudited arenot less reliable. Such information isconsidered to be more relevant fordecision-makers because of timelinessand certainty of information.

This assumption requires deferringof costs that are not related to therevenues of the current period. Theassumption of continuity allowsdepreciation on fixed assets to becharged in the profit & loss accountand show the assets in the balancesheet at net book value (cost ofacquisition less depreciation). Theincome measurement is done on thebasis of continuity assumption wherebyunexpired costs are carried to nextperiod as assets and not charged tocurrent years income. In those cases,where, it is reasonably certain that thebusiness will be liquidated in the nearfuture, the resources may be reportedon the basis of current realizable values(or liquidation value). Also, in sucha case, this fact needs to be clearlyreported in the financial statements.

2.2 Basic Accounting Principles

Basic accounting principles are thegeneral decision rules which governthe development of accountingtechniques. These principles, do notviolate or conflict with the four basicassumptions discussed above, butrefine the application thereof. Thefollowing are the basic accountingprinciples:

Duality (Dual Aspect Principle) Revenue Recognition Principle Historical Cost Principle Matching Principle Full Disclosure Principle Objectivity

These are discussed hereunder:


2.2.1 Duality

This principle states that everytransaction has two aspects. Ittherefore, implies that minimum twoaccounts will be involved in recordinga transaction. When an investment ismade by the owner in the business, itresults in increase in an asset andincrease in owners equity. Thus, thistransaction is recorded consideringthese two aspects, i.e. asset andowners equity. Every transaction willaf fect the accounting equation,whereby, there will be correspondingincrease or decrease on both sides ofthe equation or increase and decreaseon one side of the equation. Theaccounting equation is given below:

Assets = Liabilities + Owners Equity

The enterprise can acquire an assetby sacrificing another asset, incurringthe liability or receiving it from owner(resulting in increase in ownersequity). The use of accounting equationfor processing of business transactionis discussed in the next chapter.

2.2.2 Revenue Recognition Principle

Revenue recognition (Revenue reali-zation) principle helps in ascertainingthe amount and time of recognizing therevenues from the business activities.Revenues are the amount a businessearns by selling its products orproviding services to the customers.The revenue is deemed to have beenearned in the period in which the salehas taken place or services have beenperformed to the satisfaction of the

customer and the revenue has beenreceived or becomes receivable.However, there may be situationswhere, within the accounting period,sale may not have concluded orservices have not been fully rendered.This poses the problem of revenuerecognition.

Normally, the revenue is recog-nized at the point of sale when title tothe goods passes from the seller to thebuyer. However, there are few excep-tions to this rule of revenue recognition.

In a situation where thegovernment has appointed anauthority to acquire entire production,such as refine of gold, the revenue maybe recognized on the completion of therefining irrespective of the fact ofphysical transfer of goods.

In case of work to be completed oncontractual basis taking longer periodof time such as road construction,bridge construction, the revenue maybe recognized on the basis of cashreceived on partially completed andcertified works. In such contracts,payment is made on the basis of theterms of contract, which specify partialpayment in relation to the workcertified and completed. On thecompletion of contract, the remainingamount is treated as sales.

In some cases, revenue may berealized at the time of receiving cashand not at the time of providingservices. For example, a lawyer maycharge the fee from his client and treatit as revenue earned for the currentperiod, whereas legal services may beprovided in future.

26 ACCOUNTANCY

A Ltd. purchased equipment from X Ltd. for Rs. 57,000 on 1 April 1999. The freight andcartage of Rs. 1,200 is spent to bring the asset to the factory (intended condition of use)and Rs. 3,000 is incurred on installing the equipment to make it possible for the use(intended condition of use). In this case, the cost of acquisition which is the historical costis Rs. 61,200. This amount can objectively be ascertained from the invoice and henceverifiable. After the purchase of equipment even if its price increases in the market, thecompany will continue to show it at its historical cost, i.e. Rs. 61,200.

Box 2.2

The basic test, as discussed above,is used to ascertain the revenue. Therevenue from permitting other entitiesto use the enterprises asset is to berecognized as the time passes or as theasset is used. The rent from thepremises let out or interest on moneyloaned will be recognized on the basisof passage of time. The royalty may berecognized on the basis of production/sale of the products.

2.2.3 Historical Cost Principle

Historical cost principle requires thatall transactions should be recorded attheir acquisition cost. The cost ofacquisition refers to the cost ofpurchasing the asset and expensesincurred in bringing the asset to theintended condition and location of use.In other words acquisition cost is equalto buying price plus all expensesincurred to put the asset to use. Thecost is historical in nature and will notchange year after year. This impliesthat no adjustment is made for anychange in the market value of suchassets.

The advantage of using historicalcost for recording the transactions isthat it is objective, verifiable and

reliable. Thus, it imparts reliability tothe financial statements.

2.2.4 Matching Principle

Matching principle requires that theexpenses should be matched with therevenues generated in the relevantperiod. The simple rule that followedin this context is, let expenses followrevenues.

The Matching Principle by relatingexpenses to the associated revenueshelps in measuring income (profit) forthe given period. It is of greatsignificance since the performance ofan entity is usually measured in termsof income earned by the entity.

We do not recognize the expensewhen cash is paid or when a productis produced. It is recognized when theservice or the product actuallycontributes to the revenue. Therefore,expenses are not related to the periodof cash outflow but to the period inwhich the revenues are generated. Thematching principle requires that partof the cost of fixed assets used in theoperations of the business, known asdepreciation, is treated as expense ofthe period. Likewise, in case revenuesreceived in advance for which the


services have not been rendered willbe treated as unearned income, andhence, it will be carried forward to thefollowing accounting period.

2.2.5 Full Disclosure Principle

Full disclosure principle requires thatall those facts that are necessary fordischarging the accountability andproper understanding of the financialstatements must be revealed. Allmaterial information should bedisclosed fully and completely, whichis relevant for decisions to be taken byusers. The information may bedisclosed in the main body of thefinancial statements, schedules andannexure, and the footnotes appendedthereto. Further, it requires that anysignificant event, which takes placeafter the balance sheet date and islikely to affects the financial status ofthe enterprise significantly, shouldalso be reported in notes to financialstatements. There might be someclaims pending against the firm, whichif not revealed in the financialstatements will mislead the users. Theregulatory bodies like SEBI mandatesdisclosures to be made by thecompanies to portray true and fair viewof business operations to ensuredischarge of accountability. Accoun-tability is said to have been dischargedif complete information is deliveredwith due diligence by the prepares(management and accountants) of thatinformation, so that the economicinterest of the users of the informationis not adversely affected.

2.2.6 Objectivity Principle

The principle of objectivity implies thatthe accounting data should beverifiable and free from any bias. Infact, to generate the reliableaccounting information, the basicrequirements are neutrality (free frombias) and verifiability. The historicalcost recorded in the books is on thebasis of original documents, whichcontain the information, which is notaffected by the personal bias.Therefore, the accounting entries arerecorded on the objective basis and isverifiable from the source documents.Historical cost accounting, therefore,is preferred inspite of its shortcomingsdue to objectivity.

2.3 Modifying Principles

The basic assumptions and accountingprinciples discussed above provide aset of operating guidelines for thepreparation of financial statements.These guidelines are used whilepreparing the financial statementswith the basic objective of making theinformation useful for the users. Theinformation is considered to be usefulif it is reliable and relevant. Theinformation is said to be reliable whenit is free from error and bias andfaithfully represents what it seeks torepresent. The information must bebelieved to be reliable by the users fora given purpose. To ensure thatinformation is reliable it must beverifiable, neutral and faithful inrepresenting the economic condition.Information is said to be relevant if it

28 ACCOUNTANCY

influences the decision. For financialinformation to be useful, apart fromit being reliable and relevant shouldbe understandable and comparable.The financial information iscomparable when policies used areconsistent at inter-firm and inter-period levels.

Generally, the financial statementsare prepared keeping in view the basicprinciples and assumptions ofaccounting. However, difficulties areencountered in relation to theapplication of accounting principles incertain situations which call for themodified application of the principlesand assumptions of accounting. Theseconstraints are referred to asmodifying principles. These are costbenefit, materiality, consistency,prudence, timeliness substance overlegal form and industry-practiceswhich need to be considered formaking the information useful. In thefollowing paragraphs these modifyingprinciples are discussed.

2.3.1 Cost Benefit

This modifying principle states thatcost of generating the informationshould not exceed the benefits to bederived from it. Sometimes applicationof a particular principle may bedesirable but will not be beneficialbecause it does not generate materiallysignificant information but cost ofgenerating the information by usingthe principle is higher. This modifyingprinciple, implies that the cost ofapplying the principle should notexceed its benefits. It thus, plays a role

in weeding out the redundancy ininformation. For example, companiesregistered under The Companies Act,1956 were earlier required to giveunabridged annual report to all itsshareholders. But, as the number ofshareholders increased manifold andthe cost of paper and printing roseconsiderably, The Act was amended,where by, companies are now requiredto give abridged reports to theshareholders. In many developedcountries, the companies wererequired to give, on supplementarybasis, the effect of price level changeson its financial results. Since evidencesfrom recent studies suggesting that theadditional benefits from suchdisclosures were not more than thecost of providing additionalinformation, this practice hastherefore, been discontinued.

A few years before, companies wererequired to disclose detailedinformation about employees such asqualification, experience, previousemployment and relationship withdirectors if any for those drawingsalary above Rs. 36,000 per annum.Though, the information was quitecrucial in its intent, but due to increasein salaries due to inflation, even theemployees at low levels such as drivers,peons would figure in the list. Hadthe limit not been raised, this wouldhave marred the quality of information.Therefore, government was persuadedto increase the limit of the emolumentsdraws by employees to improve thequality of information and reductionof cost of information.


2.3.2 Materiality Principle

The term materiality refers to the rela-tive importance of an item. It requiresthat while recording and presentingthe financial information, the focusshould be on material items. Imma-terial items/events should be ignored.An item or event is considered to bematerial if it is likely to be relevant tothe user of financial statements. Accor-ding to this modifying principle itemsof insignificant effect or which are notrelevant to the user need not be disclosed.

The items of insignificant effect areto be viewed in relation to the size of acompany. It is not possible to definemateriality precisely since it is arelative term. An item of expense maybe insignificant for a big organization,and need not be reported separately,may not be true for a smallorganization. The amounts reported inbalance sheet and income statementmay be reported by approximating itto the nearest thousands, lacs,millions, or crores of rupees dependingupon the amounts under individualheads to be reported. For the sake ofbetter understanding while reportingthe items in financial statementsapproximate numbers are preferred toprecise numbers. The purchase ofcertain items of small amount may betreated as expense whereas in real lifethese may be carried over to nextyear. For example, stationery itemslike pens, stapler, scissors, etc. maybe treated as expense once issuedto employees for work and maybe clubbed under the head ofOffice stationery expense. However,

mate-riality varies from industry toindustry as well as country to country.

2.3.3 Consistency Principle

The Consistency principle requiresthat the accounting policies, which areused from period to period, should notchange. Hence, their application isassumed to be consistent. This impliesthat users of the financial statementhave a right to assume that accountingpolicies have been followed onconsistently followed from time totime. In case there is a change in anyof the accounting policies in aparticular accounting period, therevised statement of accounting policy,as well as, its impact on the reportedincome of the year should be disclosedclearly. The same is true when differentfirms operating in an industry followthe same accounting policies andreporting method. This helps incomparing the financial results acrossthe firms and over a period of time.The consistency helps in comparingthe accounting reports.

However, consistency principledoes not prohibit the change in theaccounting policy/method when it ispreferable to old one since the newmethod will result in more meaningfulinformation. It also requires that thenature and effect of change in theaccounting method and thejustification for the change must bedisclosed in the financial statementsin the form of footnotes. It will enablethe users of accounting information tobe aware of such facts and considerthem while using these statements.

30 ACCOUNTANCY

2.3.4 Prudence (Conservatism)

The Prudence principle is appliedwhen more than one alternative isavailable to record the transaction. Theprinciple of prudence implies that theprofit should not be over stated but allanticipated losses should be recog-nized and related. The implication ofthis is that all anticipated lossesshould be recognized and recorded,but no unrealized gain should berecognized and recorded in the booksof account. If the market price ofinvestment is lower than the cost, thenthe investments are recorded atmarket price, whereas, if the marketprice is above the cost, investmentswill be reported at cost only. In aconsistently falling market pricesituation, the inventories will be valuedat lower of cost or market price. Here,inventory is not valued at market priceby sacrificing the historical costprinciple but because of prudence,which dictates that future loss shouldbe accounted for immediately. Hence,market price, which is lower than cost,is a well-accepted principle forvaluation of inventories.

This modifying principle is appliedby choosing the alternative resultingin reporting income/assets at lowerfigure in case of great uncertainty anddoubt. This implies that errorsresulting in measuring income andassets are preferred in the direction ofunderstatement rather than over-statement. Prudence, thus, asexplained earlier, suggests that profitsare recognized only when realized(need not necessarily be in cash) but

all anticipated losses must beimmediately accounted for.

2.3.5 Timeliness

An information is useful for a decisionmaker if it is relevant and reliable.Information looses its relevance if it isnot available in time. Timeliness refersto the fact that information must beavailable to the users before it loosesits capacity to influence decisions. TheCompanies Act, therefore, requiresthat the annual reports must besubmitted to the Registrar and madeavailable to users within a specifiedperiod of time after the close of finan-cial year. It also requires companiesto publish unaudited quarterly reportsin the national newspapers.

2.3.6 Substance Over Legal Form

The transactions and events recordedin the books of accounts and presentedin the financial statements, accordingto this modifying principle, should begoverned by the substance of suchtransactions and not the legality ofsuch transactions. In certain cases,therefore, the transactions presentedmay not represent the true legalposition. For example, in contrast tooutright purchase, under hirepurchase system assets are used forbusiness purpose but ownership doesnot rest with the hire. Purchaser tillthe last installment is paid. Yet, theseare recorded at cash price as assets ofthe business. In this case, therefore,we see that substance of thetransaction gets preference over legalposition.


2.3.7 Industry Practice

The GAAP are followed by theenterprises but sometimes certainpractical considerations require thatthe enterprises in an given industrydepart form GAAP. The uniquecharacteristics of some industries mayrequire varied application of theprinciples. For example, banks aregoverned by the Banking Companies(regulation) Act, therefore, thereporting format for banks is strikinglydif ferent from other companiesgoverned by the Companies Act, 1956.Banks and insurance companies arerequired to report certain investmentsecurities at cost rather than lower ofcost or market.

2.4 Accounting Standards

Accounting is considered as a languageof business. Even language has its owngrammar providing certain set of rules,which are required to be followed.Likewise, accounting has certainnorms to be observed by the accoun-tants in recording of transactions andpreparation of financial statements.These norms become accountingstandards when a professional bodycodifies and makes them mandatoryfor recording and reporting purposes.These rules reduce the vagueness andchances of misunderstanding byharmonizing the varied applicationsand practices. Similarly, accountingalso requires adherence to certain setof rules, and guidelines, which reduces

the flexibility in preparation of financialstatements.

In 1977, the Institute of CharteredAccountants of India set up theAccounting Standards Board (ASB)with the responsibility of developingaccounting standards and issuingguidelines for implementation thereof.For the purpose of income tax, CentralBoard of Direct Taxes (CBDT) has alsoset up its own standards setting bodyto take care of the accounting practicewith regard to computation of incomeand wealth for taxation purposes.Currently, the members of the ASB aredrawn from the members of council ofICAI, representatives from Industry,Bank, Company Law Board, CentralBoard of Direct Taxes, Comptroller andAuditor General of India, SecurityExchange Board of India, etc.

ASB is assigned with the task offormulating the standards by givingdue consideration to the InternationalAccounting Standards because Indiais a member of International Accoun-ting settings body. It tries to integrateIAS to the extent possible consideringthe practices prevailing in the country.ASB has issued twenty-sevenaccounting standards and oneexposure draft on interim reportingas on as on 8 February 2002. Thestandards issued in the recent yearshave been based on IAS issued byIASC. The list of AccountingStandards and exposure draft issuedby ASB is given in the Appendix tothis chapter.

32 ACCOUNTANCY

Terms Introduced in the Chapter

SUMMARY WITH REFERENCE TO LEARNING OBJECTIVES

The transactions are recorded and financial statements prepared there from byfollowing certain rules and practices. These rules and guidelines are usually referredto Generally Accepted Accounting Principles. The understanding of these guidelinesis important for both who prepare the financial statements, and the users whoneed to use these statements.

1. Meaning of (GAAP)

Generally Accepted Accounting Principles are the set of rules and practices that arefollowed while recording transactions and preparing the financial statements.

2. Basic Operating Guidelines

Basic operating guidelines refer to assumptions, accounting principles and modifyingprinciples. These guidelines are well-established and accepted in accounting.

3. Basic Assumptions

Assumptions have been developed over a period of time and considered ascornerstones of the foundation of accounting. The four basic assump-tions areaccounting entity, money measurement, going concern and accounting period.

Accounting Entity: Accounting entity assumption, states that the activitiesof a business entity be kept separate from its owners and all other entities.

Money Measurement: Money measurement assumption requires use of moneyas a unit of measurement that is the currency of the country where theorganization is to report its operations.

Accounting Entity

Accounting Period

Accounting Standards

Basic Assumption

Basic Principles

Comparability

Conservatism

Consistency

Cost Benefit

Money Measurement

Modifying Principles

Objectivity

OperatingGuidelines

Prudence

Revenue Recognition

Substance Over form

Duality

Full Disclosure

Generally AcceptedAccounting Principles[GAAP]

Going Concern

Historical Cost

Industry Practice

Matching Principle

Materiality


Going Concern: This assumption states that the business will have anindefinite life unless there is evidence to the contrary.

Accounting Period Assumption: This assumption permits the accountant todivide the lifespan of the business enterprise into different time period knownas accounting period for the purpose of preparing financial statements

4. Basic Accounting Principles

The accounting principles are the general decisions rules, which govern thedevelopment of the accounting techniques.

Duality: This principle states that every transaction must be viewed fromtwo aspects. It therefore, necessitates that minimum two accounts will beinvolved in recording a transaction.

Revenue Recognition Principle: The revenue is deemed to have occurred inthe period in which the sale has taken place or services have been performed.There are some exceptions to the sale basis of revenue recognition.

Historical Cost Principle: Historical principle requires that all the transactionsshould be recorded at their monetary cost.

Matching Principle: Matching Principle requires that the expenses should bematched with the revenues generated in the relevant period.

Full Disclosure Principle: Full disclosure principle requires that all thosefacts that are necessary for proper understanding of the financial statementsmust be revealed.

Objectivity Principle: The principle of objectivity requires that the accounting datashould be verifiable and free from any bias.

5. Modifying Principles

There may be certain difficulties encountered while applying the accountingprinciples in a given situation. Modifying principles guide in such a situation howto encounter such difficulties and provide more reliability and understandability tothe accounting information.

Cost Benefit: This modifying principle states that cost of generating theinformation should not exceed the benefits to be derived from it.

Materiality Principle: The term materiality refers to the relative importanceof an item. It requires that while recording and presenting the financialinformation, the focus should be on material items.

Consistency Principle: The consistency principle requires that the accountingpolicies which are used from period to period should not change.

Prudence: The prudence principle requires that when more than onealternative is permissible to record a transaction, the one which results inleast favourable in immediate effect on profit or owners equity usually shouldbe adopted.

Timeliness: Timeliness refers to the fact that information must be availableto the users before it looses its capacity to influence decisions.

Substance over legal form: The transactions and events recor-ded in thebooks of account and presented in the financial statements, according tothis modifying principle, should be governed by the substance of suchtransactions and not the legality of such transactions.

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Industry Practice: The unique characteristics of some indus-tries may requirea different approach and procedure to make the financial statements moreuseful.

EXERCISES

1. State the accounting assumption/basic principle/modifying principle involved in each of the following situation:

(i) During the life time of an entity, accountants preparefinancial statements at arbitrary points in time _______________

(ii) The tendency of accountants to resolve uncertaintyand doubt in favour of overstating liabilities andexpenses and understanding assets and revenues _______________

(iii) Revenue is generally recorded at the point sale _______________(iv) The accountants assume that the business will not

be liquidated in the near foreseeable future _______________(v) The assets are recorded in books at the cost incurred

in acquisition of such assets _______________(vi) Expenses need to be recorded in the period in which the

associated revenues are recognized _______________(vii) The cash withdrawn by the owner to meet personal

expenses is recorded in the books of the businessas drawings _______________

(viii) The benefits to be derived from accounting informationshould exceed its cost _______________

(ix) The inventory are to be recorded at lower of cost ormarket value. _______________

(x) The insignificant items or events, having aninsignificant economic effect need not be disclosed _______________

2. State True or False

(i) The accountants prudence states that preference should be given for errorsin measuring assets and recognizing revenues in the direction ofunderstatement rather than overstatement.

(ii) The benefits to be derived from information should not exceed its cost.(iii) The expenses of the owners of the business need to be recorded as expenses

of business.(iv) All transactions that affect the business must be recorded.(v) The accounting data should be verifiable and free from any bias.

3. Fill in the blanks below with the accounting principle, assumption or relateditem that best completes each sentence:

(i) Companies must prepare financial statements at least yearly due tothe _____________ assumption.

(ii) The _____________ principle requires that the same accounting methodshould be used from one accounting period to the next.


(iii) Recognition of expenses in the same period as associated revenues isknown as the __________ principle.

(iv) Transactions between owner and business are recorded due to_______________ assumption.

Short Answer Questions

4. Why do accounting principles emphasize the use of historical cost as abasis for measuring assets?

5. Why it is necessary for accountants to make going concern assumption?6. When should revenue be recognized?7. What are the exceptions to the general rule of revenue recognition.8. Describe the following modifying principles:

(a) Cost Benefit (b) Materiality9. What is accounting entity assumption?10. What is the monetary unit assumption? Does it hold good when the prices

are not stable?11. Why is periodicity assumption necessary for preparing the financial

statements?12. What is the matching principle?

Essay Type Questions

13. Name the basic assumptions that underlie the financial accountingstructure?

14. Explain the effect of going concern and periodicity assumptions on financialstatements.

15. What is substance over form? Explain the implications by giving suitableexamples.

16. Explain the effect of revenue recognition principle and matching principleon financial statements.

17. What are modifying principles? What role they play in preparation of financialstatements.

18. Explain the constraints that require the accounting principles to be modified?

Check-list of Key Letters/Words

Q 1.i. Periodicity Q 2. i. True

ii. Trueiii. Falseiv. Falsev. True

Q 3. i. Periodicityii. Consistencyiii. Matchingiv. Accounting Entity

ii. Prudenceiii. Revenue Recognitioniv. Going Concernv. Historical Costvi. Matchingvii. Accounting Entityviii. Cost Benefitix. Prudencex. Materiality

36 ACCOUNTANCY

AppendixAccounting Standards (AS)

The ICAI has issued the following standards as on 8.2.2002:(Date of issue)

AS1 Disclosure of Accounting Policies (Jan 1979)

This Standard deals with the disclosure of significant accountingpolicies followed in preparing and presenting financial statements.Such policies should form part of the financial statements and bedisclosed in one place.

AS2 Valuation of Inventories (June 1981)

This Standard deals with the principles of valuing inventories forfinancial statements. For this purpose inventories include tangibleproperty held for sale in ordinary course of business, or in theprocess of production for such sale, or for consumption in theproduction of goods or services for sale, including maintenancesupplies and consumables other than machinery spares.

AS3 Cash Flow Statements (June 1981, Revised in March 1992)

This Standard deals with the financial statement whichsummarises for a given period the sources and applications offunds of an enterprise. This Standard supersedes AccountingStandard (AS) 3, Changes in Financial Position, issued in June1981. The cash flows are to be classified into three categories, viz.operating activities, investing activities and financing activities.

AS4 Contingencies and Events Occurring after the Balance SheetDate (November 1982, Revised in April 1995)

This Standard deals with the treatment if financial statements ofcontingencies and events occurring after the balance sheet date.The Standard, however, does not cover contingency situationsrelating to the liabilities of life insurance and general insuranceenterprises arising from policies issued; obligations underretirement benefit plan; and commitments arising from long-termlease contracts.

AS5 Net Profit or Loss for the Period, Prior Period Items and Changesin Accounting Policies (November 1992, Revised in February 1997)

This Standard deals with the treatment in the financial statementsof prior period and extraordinary items and changes in accountingpolicies. The Standard does not deal with the tax implications ofprior period items, extraordinary items and changes in accounting


policies and estimates for which appropriate adjustments will haveto be made depending on the circumstances. It also does not dealwith adjustments arising out of revaluation of assets.

AS6 Depreciation Accounting (November 1982)

This Standard applies to all depreciable assets. The Standard doesnot apply to assets in the category of forests, plantations and similarnatural resources; wasting assets including expenditure on theexploration for natural non-regenerative resources; expenditure onresearch and development; goodwill and live stock. This also doesnot apply to land unless it has a limited useful life for the enterprise.

AS7 Accounting for Construction Contracts (December 1983, Revisedin April 2003)

This Standard deals with accounting for construction contractsin the financial statements of contractors. The contracts may fallinto the category of fixed price contracts or cost plus contracts.The accounting for such contracts may be follow either of thepercentage of completion method or completed contract method.

AS8 - Accounting for Research and Development (January 1985)

This Standard deals with the treatment of costs of research anddevelopment in financial statements. This Standard, however, doesnot deal with the accounting implications of the followingspecialized activities: (i) research and development activitiesconducted for others under a contract; (ii) exploration for oil, gasand mineral deposits; and (iii) research and development activitiesof enterprises at the construction stage.

AS9 Revenue Recognition (November 1985)

This Standard deals with this bases for recognition of revenue inthe statement of profit and loss of an enterprise. The Standard isconcerned with the recognition of revenue arising in the course ofthe ordinary activities of the enterprise from the sale of goods, therendering of services, and the use by others of enterprise resourcesyielding interest, royalties and dividends.

AS10 Accounting for Fixed Assets (November 1985)

This Standard deals with fixed assets grouped into variouscategories, such as land, buildings, plant and machinery, vehicles,furniture and fittings, goodwill, patents, trademarks and designs.This Standard does not deal with the specialized aspects ofaccounting for fixed assets that arise under a comprehensivesystem reflecting the effects of changing prices but applies to

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financial statements prepared on historical cost basis. This alsodoes not deal with accounting for following assets: (i) forests,plantations and similar regenerative natural resources; (ii) wastingassets including mineral rights, expenditure on the explorationfor and extraction of minerals, oil, natural gas and similar non-regenerative resources; (iii) expenditure on real estatedevelopment; and (iv) livestock.

AS11 Accounting for the Effects of Changes in Foreign Exchange Rates(August 1991)

This Standard deals with the issues relating to accounting foreffect of changes in foreign exchange rates. This applies toaccounting for transactions in foreign currencies and translatingthe financial statements of foreign branches for inclusion in thefinancial statements of the enterprise.

AS12 Accounting for Government Grants (August 1991)

This Standard deals with accounting for government grants.Government grants are sometimes called by other names suchas subsidies, cash incentives, duty drawbacks, etc. This Standarddoes not deal with: (i) the special problems arising in accountingfor government grants in financial statements reflecting the effectsof changing prices or in supplementary information of a similarnature; (ii) government assistance other than in the form ofgovernment grants; and (iii) government participation in theownership of the enterprise.

AS13 Accounting for Investments (September 1993)

This Standard deals with accounting for investments in thefinancial statements of the enterprise and related disclosurerequirements. The issues relating to recognition of interest,dividends and rentals earned on investments, operating or financelease and investment of retirement benefits plans and lifeinsurance enterprise are not within the purview of this standard.

AS14 Accounting for Amalgamations (October 1994)

This Standard deals with the accounting treatment of anyresultant goodwill or reserves in amalgamation of companies. Thisdoes not apply to the cases of acquisitions where one companypurchase the shares in whole or in part of other company inconsideration of cash or by issue of shares or other securities (Insuch a case the entity of acquired company continues).


AS15 Accounting for Retirement Benefits in the Financial Statements ofEmployers (January 1995)

This Standard deals with accounting for retirement benefits inthe financial statements of employers. For this purpose, theretirement benefits considered may be in the form of providentfund, superannuation/pension, gratuity, leave encashmentbenefits on retirement, post-retirement health and welfare schemeand any other retirement benefits.

AS16 Borrowing Costs (May 2000)

This Standard deals with the issues involved relating tocapitalization of interest on borrowing for purchase of fixed assets.This standard deals with issues related to identify the assets whichqualify for capitalization of interest, the period for which the interestis to be capitalized and the amount of interest that can becapitalized.

AS17 Segment Reporting (October 2000)

This Standard applies to companies which have an annual turnoverof Rs. 50 crores or more. This standard requires that the accountinginformation should be reported on segment basis. The segmentsmay be based on products, services, geographical area, etc.

AS18 Related Party Disclosure (October 2000)

This Standard requires certain disclosure which must be madefor transactions between the enterprise and related parties. Thestandard recognised related party as an enterprise which has acommon control with reporting enterprise, associate or jointventure of reporting enterprise, individual having direct/indirectinterest in the voting power of reporting enterprise, keymanagement personnel, and enterprise over which any personhaving direct/indirect interest in voting power or key managementpersonnel is able to exercise significance influence.

AS19 Leases (January 2001)

This Standard deals with the accounting treatment of transactionsrelated to lease agreements. For this purpose the standard dividesthe agreements into operating and financing lease.

AS20 Earnings Per Share (January 2001)

This standard deals with the presentation and computation ofEarning Per Share (EPS). This Standard requires that the EPS needto be calculated on consolidated basis as well as for the parent

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(holding) company while presenting the financial statements ofthe parent company. The standard requires to compute and presentbasic as well as diluted EPS.

AS21 Consolidated Financial Statements (1.4.2001)

This Standard deals with the to preparation of consolidatedfinancial statements with an intention provide information aboutthe activities of a group (parent company and companies underits control referred to as subsidiary companies).

AS22 Accounting for Taxes on Income (1.4.2001)

This Standard deals with determination of the amount of taxexpenses for the related revenues. The tax expense will compriseof current tax and deferred tax for the purpose of determing thenet profit (loss) for the period.

AS23 Accounting for Investments in Associates in Consolidated FinancialStatements (July 2001)

This Standard deals with the principles and procedures to befollowed for recognizing, in the consolidated financial statements,the effect of the investments in associates on the financial positionand operating results of a group.

AS24 Discontinued Operations (February 2002)

This Standard lays down the principles for reporting informationabout discontinued operations, with an objective to enhance theability of users of financial statements to make projection ofenterprises cash flows, earnings generating capacity, andfinancial position by segregating information about discontinuedoperations from information about continuing operations.

AS25 Interim Financial Reporting (February 2002)

This Standard deals with the minimum content of interim financialreport and prescribes the principles for recognition andmeasurement in complete or condensed financial statements foran interim period. This Standard does not say anything about thefrequency of such reporting.

AS26 Intangible Assets (February 2002)

This Standard prescribes the accounting treatment for intangibleassets which are not covered by any other specific accountingstandard.


AS27 Financial Reporting of Interests in Joint Ventures (February 2002)

This Standard sets out principles and procedures for accountingfor interests in joint ventures and reporting of joint ventures assets,liabilities, income and expenses in the financial statements ofventurers and investors.

All the above standards issued by Accounting Standards Board arerecommended for use by companies listed on a recognized stock exchange andother large commercial, industrial and business enterprises in the public andprivate sectors.

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